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What is a Mortgage and How Does it Work?

What is a Mortgage and How Does it Work?

If you are planning to purchase a home in the near future, then you should first take some time to learn about the use of a mortgage. After you and the seller agree upon a purchase price for your desired property, you then need to come up with some way to pay that amount. Since most people don’t have that kind of money readily available, they usually make some type of down payment out of their own funds and then borrow the balance from their local community bank or credit union.

Borrowers sign a legal agreement, called a mortgage, which says that they agree to repay the money borrowed, with interest, over a specified period of time. In exchange, the bank or credit union holds title to the specified property. If the buyer does not make the required payments, the lender may take possession and try to sell it to another party. Here are some of the things you will need to know if you are going to sign a mortgage agreement:

  • Interest: You agree to repay all of the money borrowed, known as principal, plus an amount on top of that which is called interest. Your interest rate may be fixed or variable. A fixed interest rate will stay the same throughout the course of your mortgage loan. A variable interest rate may change based on the agreement itself or the financial environment, but there is usually some type of cap as to how high this interest rate can go.
  • Term: This is how long you will take to repay the money borrowed. Mortgages usually run from ten to thirty years. In general, if the mortgage is for a short term the payments will be higher, while they might be lower for a long-term mortgage. Look at the total amount of money you are committing to repay before agreeing to a specific term for your mortgage.
  • Private Mortgage Insurance (PMI): To protect its interest in the property, the lender may require you to carry this type of insurance for a specified period of time. If you fail to make payments, the mortgage insurance will cover them for you.
  • Escrow: There are certain obligations you have as a homeowner, such as taxes and home owners insurance. The lender also wants to protect its interest in your property, so it spreads out the annual amount of each item over your monthly payments, holds the money for you, and makes payments on your behalf. At the beginning of each year, the lender will perform an escrow analysis to estimate what these items will be for the coming year and notify you as to your new monthly payment amount. You may be required to pay a small amount if the escrow amount was not enough, or you may receive a refund if the expenses were less than anticipated.

Before signing any mortgage paperwork, ask questions and completely understand your responsibilities. Congratulations and good luck!