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 unless you take an interest-only loan (which is not usually a good idea). Let’s see why you mostly pay the interest during the first years of your mortgage.
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.
John Cohan says
January 8, 2012 at 9:10 AMI find it interesting that many people now a days fail to pay their mortgage. I wish we could balance out this world by pulling very strict regulations on corporations, have a representative democracy, and free schooling [even on college]. That way, any country maintaining life like this would reduce poverty by a huge margin and the wealth distribution would be fair. Life would be very peaceful in a place like this.
Valiza says
January 8, 2012 at 9:17 AMI doubt it, people seem to live in countries and mostly not care how it is run. As a bonus, most don’t understand the clockwork behind. I have a mortgage and am doing very well since I got a college degree and am progressing more in my career. I like the article on how straight – forward it is on it’s description of what a mortgage really is. I hope people will read it, that way if they are not so lucky with money they will choose an apartment over the painful situation a mortgage can bring on low-income people.
srd1281 says
September 12, 2011 at 7:53 PMHow did you determine that the monthly payments will be about $1600 in your example?
Neal Frankle says
September 12, 2011 at 8:39 PMI used my present value calculator but you can find calculators like that online.
Kellen says
December 26, 2010 at 3:46 PMThe important thing with tax benefits is to make sure that what you’re spending is not costing you more than the benefit! If you were going to get a mortgage anyway, then the tax benefit is great. If you choose to pay off you mortgage slower to keep the deduction well… you’ll probably end up paying more in interest than you save from deductions!
Neal@Wealth Pilgrim says
December 26, 2010 at 8:20 PMKellen,
Very powerful comment. Make sure you don’t pay more than the benefits of a mortgage (or anything) is worth! I love it. Nice reminder.
Greg McFarlane says
December 23, 2010 at 12:46 AMNice work, Neal. Plenty of kids coming out of college – and unfortunately, often beyond – have no idea how mortgages work. God knows schools don’t teach this stuff.
krantcents says
December 22, 2010 at 4:03 PMGood explanation. I refinanced my home with a 15 year mortgage 8 years ago. One of the unintended consequence is lower tax deduction because of lower interest. I am not complaining, but it is something to consider.
LifeAndMyFinances says
December 21, 2010 at 4:22 AMIt’s true that most of the mortgage payments in the beginning go straight to interest payments. If you are paying only the minimum amount each month, you may only pay off $1,000 of your principle the first year.
But, if you pay only a small amount more than your typical payment, all of that extra money goes toward the principle and you’ll never have to pay interest on that amount!
By paying this extra amount, it could easily cut 5 or 10 years off your mortgage!