Mortgage - Meaning and Explanation

What Does it Mean to use a Mortgage?

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A mortgage is an agreement that allows a borrower to use property as collateral to secure a loan.

In most cases, the term refers to a home loan: when you borrow to buy a house, you sign an agreement saying (among other things) that your lender has the right to take action if you don’t make your required payments on the loan. Most importantly, the bank can take the property in foreclosure – forcing you to move out so they can sell the home.

The sales proceeds will be used to pay off any debt you still owe on the property.

A mortgage is an agreement: the terms “mortgage” and "home loan" are often used interchangeably. Technically, a mortgage is really the agreement that makes your home loan work – not the loan itself. For real estate transactions, agreements need to be in writing, and a mortgage is a document that gives your lender the right to foreclose on your home.

Mortgages Make it Possible

Real estate is expensive. Most people don’t have enough cash sitting around to buy a home, so they make a down payment of 20% or so and borrow the rest. That still leaves the need for hundreds of thousands of dollars in many markets. Banks are only willing to give you that much money when they have a way to reduce their risk. Banks protect themselves by requiring you to use the property you're buying as collateral.

To do so, you "pledge" the property as collateral (in the fine print of your mortgage agreement), and that pledge is your "mortgage."

Borrowers also get some benefit out of this arrangement: by helping the lender reduce risk, the borrower pays a lower interest rate. Mortgages are often used by consumers (individuals and families), but businesses can also purchase property with a mortgage.

Types of Mortgages

There are several different types of mortgages.

Again, if you want to be a stickler, we’re talking about different types of loans – not different types of mortgages (because the mortgage is simply the part that says they can foreclose if you stop making payments).

Fixed-rate mortgages are the simplest type of loan. You’ll make that exact same payment for the entire term of the loan (unless you pay more than is required, which helps you get rid of debt faster). Fixed rate mortgages typically last for 30 or 15 years, although other terms are not unheard of. The math on these loans is pretty simple: given a loan amount, an interest rate, and a number of years to repay the loan, your lender calculates a fixed monthly payment.

These loans are simple enough that you can calculate mortgage payments and the payoff process by yourself (spreadsheets and templates make it easier). Calculations help you compare lenders and decide what type of loan to use – you might be surprised to see how a longer term loan leads to higher interest costs over the life of your loan.

Adjustable rate mortgages are similar, but the interest rate can change at some point in the future. When that happens, your monthly payment also changes – for better or worse (if interest rates go up, your payment will increase, but if rates fall, you might see lower required monthly payments).

Rates typically change after several years, and there are some limits as to how much the rate can move. These loans can be risky because you don't know what your monthly payment will be in 10 years – or if you'll be able to afford it.

Second mortgages, also known as home equity loans, allow you to add another mortgage and borrow more money. Your second mortgage lender is “in second position,” meaning they only get paid if there’s money left over after the first mortgage holder gets paid. Second mortgages are sometimes used to pay for home improvements and higher education. In the financial crisis, these loans were notoriously used to "cash out" your home equity.

Reverse mortgages provide income to people (generally over the age of 62) who have sufficient equity in their homes. Retirees sometimes use a reverse mortgage to supplement income or to get lump sums of cash out of homes that they paid off long ago.

With these loans, you don’t pay the lender – the lender pays you – but they’re not always as good as they sound.

Refinancing: mortgages can (often) be swapped out if you find a better deal. When you refinance a mortgage, you get a new mortgage that pays off your old loan. This costs money, but it can pay off over the long term if you get the numbers to line up correctly.

Getting Approved

To borrow with a mortgage, you’ll need to apply for a loan and get approved. This is rarely an easy process. Lenders need to see that you have the ability to repay the loan (partly because they don’t want to lose money, and partly because they are required to do so under federal law).

Lending decisions are typically made based on your credit and income. Credit scores are a result of loans you’ve taken out in the past: if you’ve borrowed and repaid successfully, you’ll have good scores. Lenders evaluate your income using a debt to income ratio, which looks at how much of your monthly income is taken up by loan payments.

If you have never borrowed before, you may still be able to get approved for a loan. Manual underwriting may be available, which involves a person (instead of a computer) evaluating your payment history and financial situation.

"To Mortgage" – What does it Mean?

Now that you understand what a mortgage is in the context of a loan, it might make sense when you hear that somebody "had to mortgage" something. The idea is that they wanted something valuable, and they had to pledge something else valuable in order to get the thing they wanted.

For example, if you "mortgage your future," you make a decision that will have consequences down the road. You get benefits today, but there will be costs to pay later.