What is a Mortgage? - Definition & Purpose

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  • 0:03 What is a Mortgage?
  • 0:57 Purpose of a Mortgage
  • 1:51 Components of a Mortgage
  • 4:48 Lesson Summary
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Lesson Transcript
Instructor: Aaron Hill

Aaron has worked in the financial industry for 14 years and has Accounting & Economics degree and masters in Business Administration. He is an accredited wealth manager.

Learn about one of the largest loans most people will ever encounter. Find out about the key elements to a mortgage and how a mortgage works when buying a home.

What Is a Mortgage?

A mortgage is likely the largest debt you'll encounter in your lifetime. Before you sign on the dotted line, let's explore more about what to expect when getting a mortgage.

A mortgage is a loan and legal contract to finance the purchase of a home. In return for the bank loaning you money to purchase a home, it designates your new home as collateral. If you don't make your agreed upon payments, collateral gives the bank the right to take back the property and sell it to cover the debt. The process of the bank or lender taking back a home is often referred to as foreclosure. This is something you obviously want to avoid. Instead, you'll want to repay the debt and honor your contract by making monthly installments or payments that typically include the principal, interest, taxes and insurance for the home.

Purpose of a Mortgage

Buying a home is often referred to as one of the American dreams. Many first-time homebuyers will tell you they experienced feelings of independence and accomplishment when they were first handed those keys to their very own property.

The problem with getting that first home is that it can be very expensive. It could easily take several decades to save enough money to pay cash for a home. Thus, many first-time homebuyers take out a mortgage instead.

From the borrower's perspective, mortgages help those with a stable income and adequate credit history purchase a home earlier in their lives. Mortgages also can be used to repair or renovate a home or provide additions, such as an additional bedroom or a garage, to a home. From a lender's perspective, a mortgage provides a way to make money by charging interest on a loan, while protecting themselves with collateral in case of non-payment.

Components to a Mortgage

Now, let's take a look at some of the common components of a mortgage. We'll start with term. This is the amount of time you have to repay the loan. The most common terms are for 10, 15, and 30 years. As a general rule, the shorter the term the lower the interest rate on your loan. So if you're looking to pay your house off quickly and want to pay as little interest as possible, a 10- or 15-year loan might be a good idea. If you're more concerned with having lower monthly payments than paying extra interest, a longer term loan, such as 30 years, would be a better fit. Terms for 30 years are more common with first-time homebuyers and those focused on maximizing cash flow.

Next is principal. The principal is the amount of money you borrowed to buy your home. Before the principal is financed you might be required to make a 10% to 20% down payment. This shows the lender you have a vested interest in the property and increases the chances that you won't default on your loan agreement. For example, if you purchase a $100,000 home and put down a $20,000 (20%) down payment, the loan principal will be $80,000.

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