What Is a Mortgage? Types, How They Work, and Examples

Posted on November 28, 2023
By Dj Sadam
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Finance & Business

What Is a Mortgage?

A mortgage is a type of loan used to purchase or maintain a home, plot of land, or other types of real estate. The borrower agrees to pay the lender over time, typically in a series of regular payments that are divided into principal and interest. The property then serves as collateral to secure the loan.

A borrower must apply for a mortgage through their preferred lender and ensure that they meet several requirements, including minimum credit scores and down payments. Mortgage applications go through a rigorous underwriting process before they reach the closing phase. Mortgage types, such as conventional or fixed-rate loans, vary based on the needs of the borrower.

 

Key Takeaways

  • Mortgages are loans that are used to buy homes and other types of real estate.
  • The property itself serves as collateral for the loan.
  • Mortgages are available in a variety of types, including fixed-rate and adjustable-rate.
  • The cost of a mortgage will depend on the type of loan, the term (such as 30 years), and the interest rate that the lender charges.
  • Mortgage rates can vary widely depending on the type of product and the qualifications of the applicant.

How Mortgages Work

Individuals and businesses use mortgages to buy real estate without paying the entire purchase price up front. The borrower repays the loan plus interest over a specified number of years until they own the property free and clear. Most traditional mortgages are fully-amortizing. This means that the regular payment amount will stay the same, but different proportions of principal vs. interest will be paid over the life of the loan with each payment. Typical mortgage terms are for 15 or 30 years.

Mortgages are also known as liens against property or claims on property. If the borrower stops paying the mortgage, the lender can foreclose on the property.

For example, a residential homebuyer pledges their house to their lender, which then has a claim on the property. This ensures the lender’s interest in the property should the buyer default on their financial obligation. In the case of a foreclosure, the lender may evict the residents, sell the property, and use the money from the sale to pay off the mortgage debt.

 

The Mortgage Process

Would-be borrowers begin the process by applying to one or more mortgage lenders. The lender will ask for evidence that the borrower is capable of repaying the loan. This may include bank and investment statements, recent tax returns, and proof of current employment. The lender will generally run a credit check as well.

If the application is approved, the lender will offer the borrower a loan of up to a certain amount and at a particular interest rate. Homebuyers can apply for a mortgage after they have chosen a property to buy or even while they are still shopping for one, thanks to a process known as pre-approval. Being pre-approved for a mortgage can give buyers an edge in a tight housing market because sellers will know that they have the money to back up their offer.

Once a buyer and seller agree on the terms of their deal, they or their representatives will meet at what’s called a closing. This is when the borrower makes their down payment to the lender. The seller will transfer ownership of the property to the buyer and receive the agreed-upon sum of money, and the buyer will sign any remaining mortgage documents. The lender may charge fees for originating the loan (sometimes in the form of points) at the closing.

 

Types of Mortgages

Mortgages come in a variety of forms. The most common types are 30-year and 15-year fixed-rate mortgages. Some mortgage terms are as short as five years, while others can run 40 years or longer. Stretching payments over more years may reduce the monthly payment, but it also increases the total amount of interest that the borrower pays over the life of the loan.

Within the different term lengths are numerous types of home loans, including Federal Housing Administration (FHA) loans, U.S. Department of Agriculture (USDA) loans, and U.S. Department of Veterans Affairs (VA) loans available for specific populations that may not have the income, credit scores, or down payments required to qualify for conventional mortgages.

The following are just a few examples of some of the most popular types of mortgage loans available to borrowers.

Fixed-Rate Mortgages

The standard type of mortgage is fixed-rate. With a fixed-rate mortgage, the interest rate stays the same for the entire term of the loan, as do the borrower's monthly payments toward the mortgage. A fixed-rate mortgage is also called a traditional mortgage.

Adjustable-Rate Mortgage (ARM)

With an adjustable-rate mortgage (ARM), the interest rate is fixed for an initial term, after which it can change periodically based on prevailing interest rates. The initial interest rate is often a below-market rate, which can make the mortgage more affordable in the short term but possibly less affordable long-term if the rate rises substantially.

ARMs typically have limits, or caps, on how much the interest rate can rise each time it adjusts and in total over the life of the loan.

A 5/1 adjustable-rate mortgage is an ARM that maintains a fixed interest rate for the first five years and then adjusts each year after that.

Interest-Only Loans

Other, less common types of mortgages, such as interest-only mortgages and payment-option ARMs, can involve complex repayment schedules and are best used by sophisticated borrowers. These types of loans may feature a large balloon payment at its end.

Many homeowners got into financial trouble with these types of mortgages during the housing bubble of the early 2000s.3

Reverse Mortgages

As their name suggests, reverse mortgages are a very different financial product. They are designed for homeowners age 62 or older who want to convert part of the equity in their homes into cash.

These homeowners can borrow against the value of their home and receive the money as a lump sum, fixed monthly payment, or line of credit. The entire loan balance becomes due when the borrower dies, moves away permanently, or sells the home.4

Within each type of mortgage, borrowers have the option to buy discount points to buy their interest rate down. Points are essentially a fee that borrowers pay up front to have a lower interest rate over the life of their loan. When comparing mortgage rates, make sure you are comparing rates with the same number of discount points for a true apples-to-apples comparison.

 

Average Mortgage Rates (So Far for 2023)

How much you’ll have to pay for a mortgage depends on the type of mortgage (such as fixed or adjustable), its term (such as 20 or 30 years), any discount points paid, and interest rates at the time. Interest rates can vary from week to week and from lender to lender, so it pays to shop around.

Mortgage rates sank to historic lows in 2020 and 2021, recording their cheapest levels in almost 50 years. From roughly the start of the pandemic (i.e., April 2020) to Jan. 2022, the 30-year rate average wavered below 3.50%—including an ultimate low of 2.65%.567

But 2022 and 2023 have seen mortgage rates skyrocket, setting records in the opposite direction. The 30-year average breached the 7% threshold for the first time in Oct. 2022, and this past October, it was closer to 8%, notching a 23-year peak reading of 7.79%.8

According to the Federal Home Loan Mortgage Corp., average interest rates looked like this as of Nov. 2023:

  • 30-year fixed-rate mortgage: 7.76%
  • 15-year fixed-rate mortgage
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