How do mortgages work?

Isn’t it great that you don’t need a huge amount of money to buy a home? With a mortgage, you can buy a home you want with a small portion of the price.

A mortgage is a long-term loan that a borrower obtains from a bank, thrift, independent mortgage broker, online lender or even the property seller to finance the purchase of the home. Because mortgages are such large loans, borrowers pay them off over long periods -- usually 15 to 30 years.

A mortgage is also a legal contract you sign to promise that you'll pay the debt, with interest and other costs, over the loan term. The house and the land it sits on serve as collateral for the loan. By singing documents at closing, you are giving the lender a lien against the property. If you don’t make payments as agreed, the lender can take the home and sell it to cover the debt through a legal process called “foreclosure”.

Basic Components of a mortgage

Whatever house you buy, your mortgage loan will have the following basic components.

Principal: The amount of money you borrow to purchase your home.
Principal is the sum of money you owe as a dept and interest is charged on this amount. Most lenders require a down payment, a portion of the purchase price, to be paid from home-buyer’s own fund before the principal is financed. By putting more down payment you can reduce the amount of money that will be financed.
Interest: What lenders charge to you to use their money.
Interest is expressed as a percentage called the interest rate. It accumulates over time on the unpaid balance of money you borrowed. As well as the given rate, the lender could also charge you points, and additional loan costs. You can pay "discount points" to reduce the loan's interest rate. Each point is one percent of the financed amount.

Note: Unlike consumer interest on other loans, interest paid on a home loan is tax deductible. You can save big money by using mortgage interest to reduce your state and federal income tax. Especially during the early years when most of your monthly payments go toward interest, tax savings can be significant.
Term: The amount of time you are given by a lender to repay money you borrow.
Because mortgages are such large loans, lenders allow more time to pay back -- usually 15 to 30 years. A longer term makes monthly payments more affordable. With a longer term, you can reduce monthly payments - and thus afford a bigger loan - but you will have to pay a lot more interest over the long haul.

Amortization: how you repay the debt

The tedious process of liquidating a debt by making periodic installment payments throughout the loan’s term is called amortization. If your loan is fully amortized, it is to be repaid in full by the time you’ve made your final loan payment.

Loans are amortized (repaid) with monthly payments, which mainly consist of interest and principal. Lenders spread the interest you owe on the mortgage over hundreds of payments, but breakdown of each payment changes over time based on a set repayment formula. To keep the payments stable, lenders have the majority of each month's payment go toward interest during the early years of the loan. That ratio gradually improves over time, and at the end of the term, most of your payment will apply to principal. In that way, paying down your loan amount (building your home equity) will be much slower than you might expect. You will be surprised to see how long it takes to repay just half of the original loan amount.

Understanding the amortization schedule will help you with many important loan decisions regarding loan term, whether or not to make extra payments, refinancing, and so on. To find out your amortization schedule, you can use the Mortgage Amortization Calculator: Calculate the breakdown between principal and interest in payments on your mortgage.. It allows you to enter in the amount of your loan, your loan term, and your interest rate percentage. From this information, the calculator will provide you with the amount of each monthly payment you should make, the breakdown of each payment, and the remaining loan balance.

To use the Mortgage Amortization Calculator, click here.