A mortgage is key to buying a residence for most people. Mortgage loan documents are often lengthy and full of technical terms. As such, many people either don’t read them in their entirety or don’t understand the details. As with all contracts, I recommend that you read your mortgage from beginning to end before you sign on the dotted line. If you don’t understand something, find an independent expert who does. That expert can be a financially savvy family member, friend or a lawyer. It probably isn’t your lender, real estate agent or title agent.

In this post, I explain the basics of residential mortgages and how they compare and contrast to loans in general. I illustrate how monthly mortgage payments are calculated. Probably most importantly, I identify a number of features of mortgages that could cause financial challenges if you don’t understand them or aren’t prepared for them.

## A Mortgage is a Loan

A mortgage is a loan. The key components of loans, described in this post, hold for mortgages.

### Similarities

Mortgages have the following characteristics of loans:

- You are a borrower and borrow money from a mortgage lender.
- You make a down paymentThe amount you have to pay in cash up front for your purchase More. The down paymentThe amount you have to pay in cash up front for your purchase More is the amount that you pay towards the house at the time you buy it.
- The principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:

• Credit cards: The amount of purchases you have made but not paid on your credit card ... More is the amount you borrow. That is, it is the difference between the price of the house, including closing costs, and your down paymentThe amount you have to pay in cash up front for your purchase More. - The loan has an interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More. With each payment, you pay interestA charge for borrowing money, most often based on a percentage of the amount owed. More on the remaining principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:

• Credit cards: The amount of purchases you have made but not paid on your credit card ... More. The following factors can lower your interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More:- Your down paymentThe amount you have to pay in cash up front for your purchase More as a percentage of the purchase price is higher.
- The termThe time period over which you re-pay the loan More is shorter.
- Your credit score is higher.

- Your mortgage payment includes both principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:

• Credit cards: The amount of purchases you have made but not paid on your credit card ... More and interestA charge for borrowing money, most often based on a percentage of the amount owed. More components. - Each mortgage has a termThe time period over which you re-pay the loan More. The terms of most mortgages in the US are either 15 or 30 years. In Canada, the payments are sometimes determined as if the loan has a 30-year termThe time period over which you re-pay the loan More, but the actual termThe time period over which you re-pay the loan More is only five years. More about Canadian mortgages later.

### Differences

The primary differences between loans generally and a mortgage are:

- Mortgages tend to be much larger than most other personal loans.
- Your residence acts as collateralA physical asset pledged by a borrower as security to a lender for a loan. If the borrower defaults on the loan, the lender can take possession of the collateral. More for the loan. That is, if you don’t make your loan payments, the lender can foreclose on your home (take ownership of it).

## Monthly Mortgage Payments

The three factors that influence the amount of your monthly payment are:

- Initial principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:

• Credit cards: The amount of purchases you have made but not paid on your credit card ... More (loan amount) – a lower initial principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:

• Credit cards: The amount of purchases you have made but not paid on your credit card ... More leads to a lower payment. - interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More – a lower interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More leads to a lower payment.
- Loan termThe time period over which you re-pay the loan More – a longer termThe time period over which you re-pay the loan More leads to a lower payment.

The table below compares the monthly payments on a $100,000 mortgage for interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates ranging from 2% to 5% for 15- and 30-year terms. These interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates and terms are fairly typical these days.

termThe time period over which you re-pay the loan More (years) | interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More |

2% | 3% | 4% | 5% |

15 | $644 | $691 | $740 | $791 |

30 | 370 | 422 | 477 | 537 |

As can be seen, moving from a 30-year mortgage at 2% to a 15-year mortgage with a 4% interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More doubles your monthly payment ($370 vs. $740).

To give you some context for how high monthly payments can be, I took out my first mortgage in 1982. The interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More was 16.875% for 30 years. On a $100,000 mortgage, my payment would have been $1,416. The mortgage was even more onerous than that, as it had other features that I’ll discuss below.

## FHA, VA, Traditional Residential Mortgages

In the US, there are three common ways in which residential mortgages are issued:

- Insured by the Federal Housing Administration (FHA).
- Insured by the Department of Veterans Affairs (VA).
- Uninsured (known as conventional mortgages).

BankRate has a nice chart comparing the common provisions of these approaches. You can obtain all three types of mortgages from a bank or mortgage broker. From the lender’s perspective, the presence and type of insurance affect the riskiness of the mortgage. If it is insured, the lender considers the mortgage much less risky and can offer a lower interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More.

VA-insured mortgages (i.e., VA loans) tend to be the most flexible. They do not require a down paymentThe amount you have to pay in cash up front for your purchase More or mortgage insurance. The interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More on VA loans does not depend on your credit score. There is an upfront fee and you must be a veteran to qualify for a VA loan.

FHA-insured mortgages are slightly more flexible than conventional mortgages, especially if you have a somewhat low credit score and/or only a small down paymentThe amount you have to pay in cash up front for your purchase More. FHA loans require a down paymentThe amount you have to pay in cash up front for your purchase More of at least 3.5% of the purchase price for people with credit scores above 580. For people with credit scores between 500 and 580, the down paymentThe amount you have to pay in cash up front for your purchase More must be at least 10% of the purchase price.

FHA-insured mortgages have an upfront fee to cover private mortgage insurance (discussed below), whereas most conventional mortgages do not. FHA-insured and conventional mortgages can also have annual private mortgage insurance (PMI) fees, whereas there are no annual PMI fees for VA-insured mortgages, just an upfront charge.

## Mortgage Broker vs. Mortgage Banker

The two most common ways to get a residential mortgage are to use a mortgage broker or to contact a mortgage banker directly.

A mortgage banker is an entity (often a local, regional or national bank) that issues mortgages. That is, a mortgage banker uses its own funds when loaning you money. The mortgage banker may borrow the funds from another lender or can sell your mortgage. Nonetheless, when you borrow money for a mortgage, it is the mortgage banker who is providing the cash.

A mortgage broker is like an insurance agent. The mortgage broker learns about your borrowing needs. It then contacts a number of mortgage bankers to try to find you the best deal.

Briefly, the advantages of using a mortgage broker are that it can save you time and will likely provide access to more mortgage bankers than you can contact as an individual. The disadvantages are that, as is the case whenever there is an intermediary, you may pay extra fees and the intermediaries’ interestA charge for borrowing money, most often based on a percentage of the amount owed. More may not align directly with yours. Investopedia provides a more detailed summary of the pros and cons of using a mortgage broker.

A prudent strategy is to contact several mortgage bankers directly, as well as to work with a mortgage broker. You can compare the offers and see which one best meets your needs.

## Other Provisions

One of the most important things you can do before you sign your mortgage documents is to read and make sure you understand the entire contract. One of the contributing factors to the lending crisis of 2008 was a lack of understanding by borrowers of the terms of their mortgages. There are several features that could be present in your mortgage contract that could cause you issues down the road. In this section, I’ll identify and explain several of them.

### Balloon Payment

A balloon payment is a large payment for the remaining principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:

• Credit cards: The amount of purchases you have made but not paid on your credit card ... More balance at the end of the termThe time period over which you re-pay the loan More. When there is a balloon payment, there two time periods of importance. The first is the termThe time period over which you re-pay the loan More of the loan. It determines the date that the balloon payment is due. The second is the period over which the initial principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:

• Credit cards: The amount of purchases you have made but not paid on your credit card ... More is amortized. It determines the monthly payment and how much principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:

• Credit cards: The amount of purchases you have made but not paid on your credit card ... More is paid during the termThe time period over which you re-pay the loan More. When there is a balloon payment, the termThe time period over which you re-pay the loan More is always shorter than the amortization period.

I’ll use a $100,000 mortgage with a 3% interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More, a five-year termThe time period over which you re-pay the loan More and a 30-year amortization period as an example. The monthly payment on this mortgage is $422. At the end of the five-year termThe time period over which you re-pay the loan More, the remaining principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:

• Credit cards: The amount of purchases you have made but not paid on your credit card ... More is $88,906. If your mortgage had these terms, you would have to pay the bank for the remaining principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:

• Credit cards: The amount of purchases you have made but not paid on your credit card ... More of $88,906 at the end of five years. You could either take out another mortgage or pay the balance from your savings.

I am told that this type of mortgage is very common in Canada. In fact, my daughter’s mortgage has a balloon payment at the end of five years. The contract indicates that the bank will offer her another mortgage, but with an interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More that reflects the then-current market interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates and her then-current credit score.

If interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates go up or her credit score goes down, her monthly payment could increase significantly. If she takes out another 30-year mortgage and her interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More doesn’t increase, her payments will go down because the initial principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:

• Credit cards: The amount of purchases you have made but not paid on your credit card ... More will be lower ($88,906 vs $100,000 in the example). However, if she repeats this process every five years with 30-year amortization periods indefinitely, she will never pay off the full amount of her mortgage!

### Interest-Only Loans

The payments for some mortgages include only interestA charge for borrowing money, most often based on a percentage of the amount owed. More on the initial loan amount. The monthly payment is equal to the annual interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More times the principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:

• Credit cards: The amount of purchases you have made but not paid on your credit card ... More divided by 12 (months in a year). The principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:

• Credit cards: The amount of purchases you have made but not paid on your credit card ... More never decreases on an interest-only mortgage, as there is no principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:

• Credit cards: The amount of purchases you have made but not paid on your credit card ... More in the monthly payments. Interest-only loans usually have a balloon payment after a fairly short period of time (say, five years). The balloon payment is equal to the initial amount borrowed.

An advantage of an interest-only loan is that the payments are lower. The disadvantage is that you still owe the same amount at the end of the termThe time period over which you re-pay the loan More as at the beginning.

### Pre-Payment Penalties

Some mortgages limit the timing and amounts of pre-payments. If you make pre-payments at any time other than those allowed by the terms of the mortgage, you might have to pay a penalty. As such, if you think you might want to re-pay your mortgage more quickly than the standard schedule, you’ll want to make sure that it doesn’t contain any pre-payment penalties or that you can work within their limits.

As an example, pre-payments on my daughter’s Canadian mortgage can be made only on regular payment dates and, in any 12-month period, cannot exceed 21% of her initial loan balance. The pre-payment choices are a lump sum payment of 15% of the initial loan balance, a 15% increase in payments per calendar year and doubling of one or more payments during the calendar year. She can use any or all of these options to pay the principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:

• Credit cards: The amount of purchases you have made but not paid on your credit card ... More on her mortgage faster, but is limited to only these options.

### Points Up Front

Points are a fee whose amount is determined as a percentage of the initial principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:

• Credit cards: The amount of purchases you have made but not paid on your credit card ... More. They are less common now than they were when I took out my first mortgage. Nonetheless, you want to be alert for them. In my case, I had to pay three points to the lender when my mortgage originated plus all of the other fees at closing. On a $100,000 mortgage, three points is the equivalent of $3,000. In addition, I paid the interestA charge for borrowing money, most often based on a percentage of the amount owed. More on the mortgage as part of my monthly payments.

### Adjustable Rates

Some mortgages have adjustable interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates. Mortgages with fixed interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates (fixed rate mortgages) are more common now than they were. Adjustable-rate mortgages or ARMs were more popular when interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates were high and changing rapidly.

My first mortgage, in addition to the three points, had an adjustable interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More. In my case, the interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More was set at the beginning of each year and changed based on a benchmark rate. There was a maximum amount by which the rate could change in one year and another cap on the total increase over the life of the mortgage. When the interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More changes, your monthly payment is recalculated based on the new interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More and the remaining principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:

• Credit cards: The amount of purchases you have made but not paid on your credit card ... More and termThe time period over which you re-pay the loan More of the loan.

For more details and an actual example of an adjustable rate mortgage, I suggest taking a look at this post. If you think interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates are going to stay at their currently low levels for the entire time you plan to own your home, then the recommendation to using an adjustable rate mortgage is reasonable. If, however, you plan to own your home for a long time or think interestA charge for borrowing money, most often based on a percentage of the amount owed. More rates will increase by more than a point or two from current levels any time soon, I disagree with the author’s recommendation.

#### Risks of Adjustable Rate Mortgages

In this currently very low interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More environment, you want to be very careful about adjustable rate mortgages. As an example, let’s say you borrowed $100,000 using a 30-year mortgage with a 3% initial interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More. As indicated above, your monthly payment will be $422. If the interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More increases to 4% in the second year, your payment increases to $485. If it increases again in the third year to 5%, you will have an even higher monthly payment of $552 or 31% more than your initial monthly payment.

#### Canadian Mortgages

You face a similar, but not quite as dramatic, riskThe possibility that something bad will happen. More of monthly payment increases if you have a mortgage similar to my daughter’s in Canada. Her payments wouldn’t go up as much at the end of five years for each point increase in the interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More because the balance remaining at the end of the five-year termThe time period over which you re-pay the loan More is amortized over a full 30-year termThe time period over which you re-pay the loan More and not the remainder of the 30 years in the original termThe time period over which you re-pay the loan More. However, if I remember correctly, there is no cap on how much the interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More can increase from one five-year period to the next.

### Appraisal

Before a lender commits to a mortgage, it will almost always require an appraisal of the property. The lender sets the interest rateThe percentage which, when multiplied by the face amount or principal of a financial instrument, such as a bond, savings account or loan, determines the amount of interest that will be paid to or by t... More on a loan based on its perception of the riskThe possibility that something bad will happen. More you won’t repay it. The ratio of the amount of the loan to the appraised value (loan-to-value ratio) is part of the riskThe possibility that something bad will happen. More assessment. The higher the loan-to-value ratio, the riskier the loan to the lender. If the appraisal is less than your purchase price, you may need to either increase your down paymentThe amount you have to pay in cash up front for your purchase More or renegotiate the purchase price. That is, you will be required to bring the loan-to-value ratio in line with the lender’s initial terms.

### Private Mortgage Insurance

Some lenders require private mortgage insurance (PMI) on certain residential mortgages. If you have an FHA loan or your conventional loan has a ratio of down paymentThe amount you have to pay in cash up front for your purchase More to your purchase price of less 20%, the lender will likely include a charge for PMI with your monthly payments. There are ways to avoid this charge that you’ll want to research if you have a smaller down paymentThe amount you have to pay in cash up front for your purchase More.

PMI is insurance that protects the lender in case you default on your loan. You get the benefit that the lender is willing to give you a mortgage. Other than that, you get no benefit from PMI even though you pay for it. PMI often costs between 0.5% and 1% of the outstanding principalThe amount of money you borrowed or deposited, excluding any accumulated interest. Some examples include:

• Credit cards: The amount of purchases you have made but not paid on your credit card ... More of your mortgage annually. Once your loan-to-value ratio has increased enough, you can ask your lender to cancel this insurance.

### Bundling of Expenses

Some lenders require that you bundle your property tax and homeowners insurance costs into your mortgage payment. This bundling increases the lender’s confidence that these bills will be paid. If you don’t purchase homeowners insurance and your home is damaged or destroyed, you are much less likely to re-pay your lender for the mortgage. And, if you don’t pay your property tax bills, eventually the local authorities can foreclose on your property which could significantly diminish the value of the lender’s collateralA physical asset pledged by a borrower as security to a lender for a loan. If the borrower defaults on the loan, the lender can take possession of the collateral. More.

The benefit of this bundling of expenses is that you don’t have to remember to make the separate payments for property taxes and insurance. It can be particularly beneficial as both insurance and property taxes are often large bills that need to be paid only once or twice a year. Many people find it easier to budgetA plan showing targets for income and expenses over a fixed time period, such as a month or a year. More for those large expenses by paying them monthly.

The drawback of having your expenses bundled is that the lender often overestimates the amount of these expenses, so you pay more each month and get back the difference on a periodic basis. It also makes it a bit more inconvenient if you want to change insurers.

## Related Topics

If you are later in life or have parents who own their home, a reverse mortgage is a variation of a mortgage that might be an option. Reverse mortgages can be very useful in the right situation but are often misunderstood leading to disastrous financial consequences.

Susie Q is a retired property-casualty actuaryA professional who assesses and manages the risks of financial investments, insurance policies and other potentially risky ventures. Source: www.investopedia.com/terms/a/actuary.asp More and mother of two adult children. As her children were moving from their teens into their 20s, she found she was frequently a resource on many, many financial decisions and she had insights and information she could provide to them. She spent a significant portion of my career building statistical models of all of the financial risks of an insurance company and interpreting their findings to help senior management make better financial decisions. She is the primary author at Financial IQ by Susie Q and volunteers with other organizations related to financial education.