What are Mortgages? | by Wall Street Survivor

What are Mortgages? | by Wall Street Survivor 

Presented by WallStreetSurvivor.com, a mortgage is a loan by a bank or other financial institution that a person can use to finance the purchase of a home. A mortgage is different from other loans like personal or student loans, since the bank can use your house as collateral—meaning if you don't pay the bank back on time, they can take possession of your home.

Here is Mark and Lisa. Mark and Lisa are newlyweds looking to buy their first home. After a long search, they find the perfect home—with the not-so-perfect price tag of $500,000, more than they have in the bank. What are they to do?

Mark and Lisa head over to the bank. The banker suggests that they take out a mortgage to finance the home. The banker asks them how much they are willing to put down as a down payment. The down payment is the amount that Mark and Lisa pay up front. Usually, a down payment needs to be at least around 20% of the price of the home, but this amount varies from bank to bank.

Mark and Lisa have been saving for a while and decide to put down $100,000, meaning they will need to borrow an additional $400,000 to buy the house. The banker reviews Mark and Lisa's credit reports and income statement and grants them a $400,000 mortgage at a fixed rate of 5% with a 5-year term and a 40-year amortization period.

That means Mark and Lisa must pay a 5% interest rate to the bank per year. The fixed 5-year term means Mark and Lisa are locked into this rate for 5 years regardless of whether the interest rates go up or down. Conversely, they could have taken a variable or floating rate, which goes up and down with the interest rates. Fixed rates are considered to be the safer choice but are often a little more expensive than variable rates.

The amortization period is the length of time Mark and Lisa will take to pay off the loan and own their home entirely. So with monthly interest and principal payments, they will be the sole owners of their home in 40 years.

The advantage to taking a mortgage should be pretty clear. Instead of putting money into a landlord's pockets by paying rent, every time they make a mortgage payment they own a little more of their home. Currently, the house is split between equity (what Mark and Lisa own) and debt (what the bank owns). Every time they make a payment, they turn some of their debt into equity.

Also, Mark and Lisa could make a nice profit if the value of their home appreciates. For example, imagine Mark and Lisa get an offer to sell their home for $600,000 the day after they bought it. Mark, Lisa, and the bank aren't partners—they don't have to split the profits. So let's say they take the offer and sell the house. They collect $600,000 from the buyer and pay back the $400,000 loan to the bank. Just like that, they doubled their $100,000 investment.

To learn more about mortgages and other personal finance topics, head over to WallStreetSurvivor.com.