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What Is a Mortgage?

Mortgages allow investors and real estate buyers to purchase more with less money up front. Here's how they work.

Mar 27, 2021 by Liz Brumer
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Mortgages are commonly used to buy real estate. Rather than paying cash for a property, individuals, including real estate investors, can take out a mortgage, borrowing money from a financial institution to purchase the property, and repaying the debt back over time. If you're looking at options for purchasing property and aren't familiar with what is a mortgage, continue reading to learn what a mortgage is, the various types of mortgages that exist, how they work, and common terms of a mortgage loan.

What is a mortgage?

A mortgage is a legal contract between a borrower and lender that outlines the terms for repayment of a loan, called a promissory note. The promissory note designates the amount borrowed, interest rate, and other terms of debt repayment. The mortgage designates the roles, rights, and obligations of the parties and securitizes the lender with the property in the event of default on the promissory note. This can include who's responsible for paying property taxes, property maintenance, property insurance, or any obligation to have mortgage insurance, as well as the legal actions required to regain title to the property through a foreclosure action.

Many people refer to a note and a mortgage as if it's one document, but they are actually two separate documents created in conjunction during the financing transaction for a real estate loan. The mortgage is what secures the note, making the home or property loan a secured loan.

How mortgages work

If someone wants to purchase real estate but doesn't have the up-front money or wants to pay for the property in cash, they can apply for a mortgage. Lending institutions, including a bank, nonbank lender, or credit union, will lend a portion of the purchase price to the borrower, usually after receiving a down payment.

The principal, or total amount lent to the borrower, is then repaid with interest over a specified period of time, called an amortization period. The principal and interest (P&I) is repaid each month until the loan matures in full. The amortization period shows how the principal and interest is applied over the length of the loan. In most amortization periods, P&I payments repay more interest than principal at the beginning of the loan, until around the halfway point, at which time more of each monthly payment goes to the principal than interest moving forward.

Types of mortgages

There are several different types of mortgages. The type of mortgage loan you may apply for or receive will depend on the type of real estate you're buying, the amount of the loan, your creditworthiness or qualifications, and the use of the property. The various types of mortgages will have different terms for repayment and/or have different requirements in order to qualify.

Fixed-rate mortgage

The most common type of mortgage in real estate today is a fixed-rate mortgage. A fixed-rate loan means the annual percentage rate (APR), or interest rate, is locked for the duration of the loan, which could be a 15-year, 20-year, or most commonly, 30-year mortgage -- for example, receiving a 4% APR for the entire 30 years of the loan.

This type of mortgage is appealing because it locks in a set monthly mortgage payment. Longer repayment periods make the mortgage payment more affordable. However, the longer the term of the mortgage, the more the borrower will pay in interest.

Adjustable-rate mortgage

An adjustable-rate mortgage (ARM) is when the mortgage rate changes periodically over the life of the loan. ARMs are typically tied to an index, adjusting periodically according to a repayment schedule outlined in the promissory note, and typically include a balloon payment.

You may see an adjustable rate mortgage as 5/1, 7/1, or even 10/1. The first number indicates the term for repayment before the balloon is due, and the second number indicates the number of times in a given fiscal year the rate adjusts. Using the example of a 5/1 ARM loan, the mortgage interest could start at 4% but adjusts 0.05% every year, with a balloon on year five.

Adjustable-rate mortgages were popular just prior to the Great Recession because of the lower initial interest rate. While far less popular for residential home loans today, adjustable-rate mortgages can still be found frequently among commercial real estate loans.

Balloon mortgage

A balloon mortgage can have an adjustable interest rate or fixed interest rate, but instead of the loan being repaid in full over the entire amortization period, the loan matures, or balloons, on an earlier date.

For example, a loan can be amortized over a 30-year period but "balloons" and becomes payable in full in year 10. Balloon mortgages can provide borrowers with a lower monthly payment similar to what they might achieve with a conventional mortgage and are very common in the private mortgage market and with commercial loans.

Jumbo loan

A jumbo loan is a mortgage that exceeds the conforming loan limits set by the Federal Housing Finance Administration (FHFA), which at the time of this writing starts at $548,250, depending on the location of the property.

Second mortgage

A second mortgage is a subordinate mortgage, meaning the loan is taken out after an existing mortgage and thus falls in a secondary position in the event of mortgage default. A common example of a second mortgage is a home equity line of credit (HELOC), which taps into a homeowner's equity.

Reverse mortgage

A reverse mortgage is a specific loan created for homeowners ages 62 and up who want to tap into their homes' equity, borrowing against the value of their home. Lenders can issue a reverse mortgage with a lump payment, with fixed payments over time, or as a line of credit, drawing on the limit amount on an as-needed basis. The type of reverse mortgage taken will determine the method and terms of repayment, typically payable in full when the homeowner dies or sells the property.

Common mortgage terms

The terms of a mortgage will vary dramatically, depending on the type of loan program as well as your creditworthiness. Lenders will look at things like your credit score, credit history, down payment, job history, income, and debt-to-income ratios, among other factors.

There are several government-backed loan programs that require no or very little down payment from a borrower. Veterans, servicemembers, and eligible military spouses can apply for a VA loan, which is insured by the U.S. Department of Veterans Affairs. First-time homebuyers often apply for an FHA loan, which is insured by the Federal Housing Administration and typically requires a minimum of 3.5% down and a credit score of 580 or higher. Homebuyers in rural areas can apply for a USDA loan through the U.S. Department of Agriculture.

A conventional loan, which is a fixed-rate mortgage, requires a minimum of 20% of the purchase price as a down payment and can be amortized over 15 or 30 years. For example, if a property costs $100,000, the borrower would be expected to put $20,000 down, in addition to closing costs or loan fees. Conventional loans are typically required for investment properties, and lenders usually look for higher credit scores and strong credit history.

Commercial real estate loans typically have shorter loan periods than residential mortgages, lasting anywhere from 5 to 10 years. However, some government-backed loan programs provide fixed-rate mortgages for longer terms, such as 15 to 20 years. Most require a minimum of 20% to 25% down, but some loan programs require as little as 10% down.

Right now, mortgage rates are at record lows, meaning it's a great time to consider buying a property, refinancing, or taking out a line of credit. United Wholesale Mortgage recently marketed a 30-year loan at just 2.5% interest. However, most competitors now are falling between 3% to 3.5% for a 30-year loan. The lower the interest rate, the more affordable the monthly payment and the less interest you pay over the life of the loan.

The Millionacres bottom line

Mortgages can be a really helpful way to purchase real estate and leverage the value of a property as an investor. However, it's important to understand the financial commitment of the loan and responsibilities of owning property. Borrowers should always factor in the cost of homeowners insurance or property insurance, property taxes, and property maintenance in repairs. Some lenders will even require property taxes and insurance to be collected each month as a part of the mortgage and placed in escrow. The loan servicer will then pay the property insurance and taxes each year when they come due.

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