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Money and Finance

How a Mortgage Works

What is a mortgage?

A mortgage is a special type of loan used to buy a house. Most people don't have the cash to buy a house, so they get a loan from the bank. They pay back the loan over a long period of time by making a payment each month. The bank makes money because they charge interest on the loan.

Types of Mortgages

There are several different types of mortgages. The main differences between the types include how long the loan is for and the way the interest rate is calculated. Here are a few of the main types of mortgages:

Fixed Rate - Fixed rate mortgages have the same "fixed" interest rate for the entire loan. The interest rate never changes. You can get fixed rate mortgages for different lengths of time. The most common lengths are 10 years, 15 years, and 30 years. The shorter the period of time, the faster you pay off the house, but also the higher the monthly payment.

Adjustable Rate - Adjustable rate mortgages are usually referred to as ARMs. The interest rate on these mortgages can change over time. Generally, the starting interest rate is lower for an ARM than for a fixed rate mortgage, but it could rise rapidly if interest rates go up.

Balloon Mortgages - These type of mortgages have a low interest rate for a certain amount of time, then the remaining balance of the loan is due. This is good for people who plan to sell their home after a short period of time.

Principal and Interest

There are two main parts of a mortgage: the principal and interest. The principal is the money that was borrowed to pay for the house. The interest is the payment to the bank for borrowing the money.

Each month you pay some principal and some interest. At the start of the loan, most of the monthly payment goes for interest. Over time, more of the principal will be paid off and, by the end of the loan, the majority of the monthly payment will go towards the principal.

Home Equity

The amount of the home that you own (vs. what the bank owns) is called your home equity. For example, if your house is worth $250,000 and you still owe the bank $200,000, then your home equity is $50,000.

Collateral and Foreclosure

One important part of a mortgage is collateral. The bank only agrees to give you such a large amount of money because your home is considered collateral. This means that if you don't make your monthly payment, the bank can take ownership of your home. This is called foreclosure.

The Monthly Payment

Each month you make a payment on your mortgage. As we discussed above, this includes some money to pay on the principal and some interest. However, this isn't all that is included in the monthly payment. There are additional things included in many mortgage payments such as:

Taxes - Yes, you have to pay taxes on your home called property taxes. Property taxes can be a lot of money. Taxes are added to your monthly payment because the bank wants to make sure you pay them.

Home Insurance - You also need insurance on your home. This protects you (and the bank) if your home burns down or gets damaged in some way.

PMI - In some cases, the bank may require that the home owner pay private mortgage insurance (PMI). This is additional protection for the bank if you can't make your payment.

Interesting Facts About Mortgages

Learn More about Money and Finance:

Personal Finance

Filling out a Check
Managing a Checkbook
How to Save
Credit Cards
How a Mortgage Works
How Interest Works
Insurance Basics
Identity Theft

About Money

History of Money
How Coins are Made
How Paper Money is Made
Counterfeit Money
United States Currency
World Currencies
Money Math

Counting Money
Making Change
Basic Money Math
Money Word Problems: Addition and Subtraction
Money Word Problems: Multiplication and Addition
Money Word Problems: Interest and Percent


How Banks Work
How the Stock Market Works
Supply and Demand
Supply and Demand Examples
Economic Cycle
Adam Smith
How Taxes Work
Glossary and Terms

Note: This information is not to be used for individual legal, tax, or investment advice. You should always contact a professional financial or tax advisor before making financial decisions.

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