How a Mortgage Works, in Plain English

by Neal Frankle, CFP ®

If you are just about ready to buy your first home, you will be more confident if you understand how a mortgage works. The good news is that it’s not all that complicated.

A Mortgage Is a Loan

A mortgage is just a loan that you promise to repay. These loans are usually very large, and in order to guarantee your repayment the person who loans you the money (usually a bank) uses your house as collateral.

If you fail to repay the loan, the people who made the loan to you will force you to vacate the home. They do this through a nasty process called foreclosure. Once they get you out of the house, they’ll just sell it to someone else.

So one thing that makes a mortgage different from other types of loans is that it is backed up by something – in this case, your home. They call this a “collateralized loan.” Credit cards are also loans, but they aren’t backed up by anything. If you fail to make your credit card payments, the credit card companies can’t take your home away from you.

Mortgage Payments

Every month, you’ll make mortgage payments. Unless you have an interest-only mortgage, part of your mortgage payment goes towards the principal – that’s the amount you borrowed.

Another part of the payment you make goes towards the interest you owe the lender. For example, let’s say you borrow $300,000 for 30 years at 5%. Your payments will be about $1,600 a month. During the first year, almost all of that $1,600 goes towards interest, and here’s why.

If you take a look at your $300,000 balance and multiply it by 5%, you’ll see that you owe $15,000 in interest during the first year. $15,000 divided by 12 months is $1,250. So out of each monthly payment you make, $1,250 goes toward interest and the balance ($350) goes toward the principal that you borrowed.

Now, your monthly payments on a fixed mortgage remain at the same amount for the entire period of the loan. But your balance gets a bit lower every month. As a result, a tad more of the monthly mortgage payments go toward the balance. So, over time, more and more of your money goes towards the balance and less and less is charged for interest.

Less is charged for interest because your balance is lower and lower. But keep in mind that (at least for now) the interest you pay is deductible for tax purposes. That means if you pay $15,000 in interest this year, you will effectively reduce your taxable income by $15,000. If you’re in the 30% tax bracket, that saves you $5,000 in taxes. In short, for many people, having a mortgage is smart financial tax planning.

Let me just close by saying that I salute you. Everyone talks about mortgages all the time, but not everyone understands how they work. I know that sometimes people feel they should know, so they are embarrassed to even ask. Here’s a reminder: the only silly question is the one you don’t ask.

 

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