Unless your bank account has enough muscle to pay for a $500,000 house up front, if you’re a homeowner you most likely have a mortgage loan tied to your name.
The question of “what is a mortgage?” still arises, even though mortgages have been heavily integrated into the American way of life. They picked up speed and gained increased popularity in the 1980s when banks approved mortgage loans at an accelerated rate.
In 2010, U.S. mortgage origination (i.e. the making of new mortgages) amassed to a total $1,572 billion, according to the 2012 Census. Despite the fact that consumers regularly turn to mortgages for financial assistance when buying a home, some Americans still don’t completely understand the how a mortgage works.
Defining What is a Mortgage
When seeking a proper explanation to learn what is a mortgage, some turn to the dictionary definition.
The Merriam-Webster dictionary explains mortgage as “a conveyance of or lien against property (as for securing a loan) that becomes void upon payment or performance according to stipulated terms.”
In other words, potential home buyers use the property in question (i.e. the house) as collateral to borrow money from a lender. For this reason, until mortgages are repaid in full, the lender — or bank in most cases– actually retains legal ownership of the property.
Types of Mortgages
At one point, there was only one type of mortgage available, which didn’t give borrowers much flexibility in terms of interest rates and term lengths. There is more diversity among mortgage types these days, so finding a mortgage for your unique situation is an easier task.
Fixed Rate Mortgage (FRM)
A fixed rate mortgage is the most stable mortgage loan type borrowers can sign up for and is often referred to as a “plain vanilla mortgage.” Fixed mortgage rates never change from the start of the loan to the end of the loan term. The ability to know what to expect on monthly mortgage payments is a convenience that is highly sought after, as it eliminates the panic from increased mortgage payment requirements.
30-year fixed mortgage rates are a popular option for first-time home buyers, again due to the static mortgage rates but also because they allow Americans to pay off the home over a longer period of time, in turn lowering month payments. While 30-year fixed mortgages are standard, various term lengths are available to home buyers, like 15-year fixed mortgage loans and 10-year fixed mortgages for those who want to reduce the amount of interest accumulated on the loan.
Adjustable Rate Mortgage (ARM)
Understanding what is an ARM loan can potentially save you money over time, depending on your financial circumstances. An adjustable rate mortgage, also known as a variable rate mortgage, differs from a fixed mortgage in that mortgage rates fluctuate over the life of the loan. Despite the uncertainty of interest rates from year to year, ARMs offer appealing low rates at the beginning of the loan term (and possible throughout the loan) for those who are willing to take the risk of potentially higher mortgage rates down the line.
Since ARMs can be detrimental to the financial stability of borrowers, the mortgage industry places “caps” to enact limitations on how much mortgage rates can be adjusted. These caps protect home buyers by restricting how often a mortgage lender can change rates, determining when mortgage rate changes can be expected (e.g. common adjustment periods occur at the end of each year the loan is active), and the overall change in interest rates from the beginning to end of the mortgage loan term.
As you compare mortgages available from different lenders, you may come across a mortgage classified as a hybrid ARM. As the name suggests, hybrid ARMs combine the characteristics of a fixed rate mortgage and an adjustable rate mortgage into a single package that gives borrowers the some balanced benefits.
Hybrid ARMs are sometimes displayed as an X/Y value. For example, 3/1 ARMs, 5/1 ARMs and so on. The first number (X-value) represents the term duration for the initial mortgage rate borrowers receive, like a 3-year fixed interest rate as shown in the first example. After the third year, the interest rate adjusts like that of a traditional ARM every one year — hence, 3/1. This type of mortgage is commonly available up to a 10/1 ARM, with some financial institutions offering longer fixed interest rate terms.
How to Compare Mortgages
If you find yourself stuck trying to compare mortgages or even questioning whether you can afford a mortgage payment, consider using a mortgage calculator. With this tool, you can assess how much of an APR you and your monthly budget can stomach. If you find that a 1-2 percent mortgage rate fluctuation could potentially push your finances into the deep end, you may benefit from being able to rely on a fixed rate mortgage loan.
This article is part of the Go Banking Rates Financial Literacy Movement, helping Americans get smarter and grow richer. Take our mortgage quiz to test how knowledgeable you are!