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What is a Mortgage & How Do They Work?

By Wendel Clark | April 20, 2016

A mortgage in its simplest form is a loan used to finance the purchase of land, house & land, commercial building & land or commercial land (which will be referred to as property henceforth). The property is used as collateral for a loan. So, when buying a home, it is often possible for someone to use that property as security for the loan. It is important to remember that in order to get the loan you will have to meet certain criteria's as set out by the mortgage company/institution and that while most mortgage institutions have their own policies and procedures, they generally operate in the same way.

There are four main parts to Mortgages: The collateral you used to secure the loan, the Principal, the Interest Payments, and the Insurance. Majority of Mortgages last for between 15-30 years of monthly payments.

The Collateral: When you agree to a mortgage, you are signing a legal contract promising to repay the loan plus interest and other costs associated with the mortgage. Simply put, your home is the collateral for the loan. If you do not repay your mortgage, your lender has the right to take back the property and sell it to cover the debt owed to them, in a process known as foreclosure. In a foreclosure, you will lose your home.

Principal: The principal simply put, the sum of money you borrow to purchase your home.

Interest: The interest is what the lender charges you to use the money you borrow, usually expressed as a percentage called the interest rate. In addition to the interest rate, the lender can also charge you additional costs related to the mortgage. Such costs are often called 'closing costs' but should not be confused with the closing costs associated with the purchase of the property which are different altogether. The Principal and the interest comprise the bulk of your monthly payments in a process called amortization, which reduces your debt over a fixed period of time. With amortization, your monthly payments largely go toward paying off the interest in the early years and gradually reduces the principal later on.

Home Insurance: Lenders will not let you close the deal on your home mortgage without Home Insurance. Home Insurance, usually covers your home against fire & natural disaster (hurricanes, floods, etc).

Length of Time

Another important consideration when obtaining a mortgage is the length of time for which you will have the loan. Oftentimes, the determining factor is how much you will have to repay each month. Most people take the longest loan period possible because the resulting monthly payments will be lower.

While you may not have a choice due to financial constraints at the time, it is important to remember that the longer the loan period is, the more you will pay overall. While the principal amount (the amount you borrow), stays the same, with a longer loan period what changes is the interest.

So for instance, a person borrowing $500,000 for 5 years (amortized over 30 years) at an interest rate of 6%, they could make a monthly payment of approximately $2,974,12 resulting in a total of $178,447 for the 5 years’ term, of which, $35,138 goes to Principal and $143,308 goes to interest. Someone who borrows the same amount at the same interest rate for 25 years could make a monthly payment of $3,199.03 and would pay $191,941.80 for the 5 years term period, of which, $50,799.84 goes to Principal and $141,141 goes to interest.

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