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How a mortgage works

Updated on July 23, 2012
Terraces in Glebe, suburban Sydney, Australia
Terraces in Glebe, suburban Sydney, Australia | Source

The basics of mortgages

A mortgage is a loan from a bank, building society, savings and loans or other financial institution which is secured on real estate, i.e. on residential or commercial property. That means that if you fail to pay your mortgage the bank or whoever holds the mortgage can repossess (claim ownership of) your property.

Most people who buy a residential property to live in do so with a mortgage. Many investors who buy property to let it out also use a mortgage to do so.

For most mortgages the bank charges interest on the outstanding amount of loan until it is repaid. An exception to this is Islamic mortgages, because Islam forbids the charging of interest. Islamic mortgages are set up in a slightly different legal structure but the overall effect is similar.

For most people a mortgage is the largest and most significant financial product they will take out in their entire lives, with the possible exception of a pension. So it makes sense to understand something about how they work.

Equity, negative equity and loan to value

Mortgage lenders will put a limit on how much you can borrow. This is sometimes expressed as a percentage, the loan to value. This is the amount of the loan divided by the total value of the property.

The mortgage company will usually charge you for a mortgage valuation which they will use to assess the value of the property.

Mortgage lenders will often have different deals available for people with different levels of loan to value. Generally the lower the loan to value the less risk you are to the mortgage lender so they will charge you a lower rate.

If your house is worth $100,000 and you have a mortgage for $90,000 then your loan to value is 90%. The $10,000 excess value of the house over your loan amount is called your equity. If your outstanding mortgage debt is greater than the value of your house you are said to be in negative equity.

In some countries (like the USA) mortgage debt is what is called "non-recourse". That means that you can give the house back to the mortgage company and you don't owe them another cent, even if you are in negative equity.

In other countries (like the UK) mortgage debt is "full recourse". That means that if you are in negative equity, even if you give your house to the lender you will still owe them the difference.

Repayment or Interest Only

The term of a mortgage is how long it lasts, that is the length of time that you have borrowed the money for. At the end of the term all the money must have been repayed.

In broad terms there are two choices for repaying a mortgage.

1. A repayment mortgage - this is where you pay off the loan a little bit at a time over the term of the mortgage.

2. An interest only mortgage - this is where you only pay the interest every month but then repay the whole of the mortgage at the end.

For an interest only mortgage you should have some other savings or investment building up so that you can pay the mortgage at the end of the term. Some people plan to sell their house or remortgage at the end of the term but that is risky as there is no guarantee you will be able to do so.

In the past many people took our endowment assurance policies as an investment to pay off their mortgages, sometimes these were referred to together with the interest only mortgage as "endowment mortgages".

A mortgage example

It is probably clearest to see what is happening with an example.

Let's say that Joe takes out a repayment mortgage for $100,000. His friend Christine takes out an interest only mortgage for $100,000. They both are being charged 5% per year.

Christine will pay 5% x $100,000 = $5,000 a year, which is $417 a month.

The maths is a bit more complicated for Joe but he will pay $578 a month. As you can tell most of this ($417) is interest at the start, but as time goes on the outstanding loan amount will fall and less and less interest will be charged.

After one year Christine will still owe $100,00 but Joe will only owe $97,905. He will have paid off $2,095.

There's a lot more to find out...

There is a lot more to find out about mortgages - mortgage companies offer lots of different products with different interest rates and different guarantees and offers and charges. I also haven't discussed Islamic mortgages as they work in a different way.

There are plenty of resources on the internet for further research. You may also like to speak to a professional advisor where you are who will be able to advise you about products that will fit your personal circumstances.

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