A mortgage loan is a loan where real property is collateral for the loan.
In many countries, a mortgage loan is the most common way for ordinary people to obtain enough money to buy real estate, including single-family homes for private use.
Compared to unsecured loans (loans with no collateral), mortgage loans are considered less risky for the lender. If the borrower doesn’t pay the lender as agreed, the lender can force a sale of the property and let the proceeds from that sale repay the loan.
There are plenty of things that you can do to become more attractive to lenders and attract a lower mortgage rate. You can read more about what you do in our article here. The most important thing you can do is to save and invest money so that you can afford a larger down payment. You can read more about to do that here.
As mentioned above, the lender can force a sale of the collateral if the borrower doesn’t keep up with the payments. But what happens if the sale of the property doesn’t bring in enough money to cover the size of the mortgage loan?
In some parts of the world, mortgage loans are non-recourse loans. This means that if the sale of the property doesn’t bring in enough money, that’s not something that the borrower has to worry about. The lender is not allowed to go after the lender to get the rest of the money. The lender accepted the property as collateral for the mortgage loan and must now suffer the consequences of that decision.
With a non-recourse mortgage loan, many lenders are unwilling to let you borrow close to the full market value of the property that will be used as collateral. They need a fairly big gap between debt size and market valuation, to protect themselves against a decreasing property value decreases or you defaulting on the loan and racking up added debt in the form of administrative fees, costs associated with the foreclosure process, etc.
In some countries, evicting someone from their primary residence is very difficult (legally and/or practically). In such countries, lenders tend to be unwilling to accept a household’s primary residence as collateral for a mortgage loan.
In countries were it is very easy (both legally and practically) to evict someone and force a sale of real property, lenders tend to be more willing to accept mortgage loan applications even for applicants with low, irregular or poorly documented income. The lender’s estimation of how the real property will maintain or increase in value becomes the most important aspect when making a decision about the loan application.
With a fixed rate mortgage loan, the interest rate is fixed for the duration of the loan. One example of a country where FRM loans are the norm is the United States.
In the United States, it is very common for FRM loans to be paid back in equally sized installments throughout the lifetime of the loan. This means that when you start out paying, a large percentage of each payment will go towards paying the interest rate. As you gradually decrease the size of the debt over time, more and more of each payment can go towards amortization.
Another, less common, payment schedule type consists of large monthly payments at the start of the loan term. The size of the monthly payments will then gradually decrease as the lender reduces the size of the debt.
In countries where FRM loans are common, refinancing tend to be common as well. When you refinance a FRM loan, you take out a new FRM loan and immediately use the money to pay back your old FRM loan in full. Doing it like this is necessary since you can’t negotiate a new interest rate on your existing FRM loan.
With an adjustable rate mortgage loan (ARM loan) the interest rate is not fixed for the duration of the loan. This type of mortgage loan is very common in Europe.
Most lenders will not allow the interest rate of the loan to actually fluctuate on a daily basis, reflecting the market rate. Instead, it is common to fix the interest rate for a certain amount of time, e.g. 3 months, one year or three years.
A lender that takes out an ARM loan will not know in advance how large the required monthly or quarterly payments will be for the duration of the loan.
A mortgage loan where the borrower doesn’t gradually amortize the loan during the lifetime of the loan is commonly known as an interest-only mortgage loan, since the monthly payments to the lender will be used to cover the interest only. When the end of the loan term is reached – or when the collateral is sold, which ever happens first – the borrower must pay back the debt in full as a lump sum repayment.
An unusual type of mortgage loan is the variant where you make no payments to the lender until the end of the loan’s term or when the collateral is sold, what ever happens first.
This type of mortgage loan is chiefly marketed to elderly owners of real estate who have already paid down their original mortgage loan and thus have a lot of equity in their house. This type of mortgage loan will give them cash in hand without forcing them to sell their home.
Mary and Greg Smith own a house where they have lived for 30+ years. They have paid off their original mortgage. Both of them are 70 years old and retired. They are in good health and like to travel, visit their grandchildren, explore new restaurants and generally enjoy their golden years. However, with both of them being retired, money is a bit scarce despite not having a mortgage loan anymore. Also, the roof of the house could really benefit from a renovation, but finding money for this in their budget would require sacrifices.
They like their house, but plan to sell it within the next 10 years to move into an apartment before the house becomes to much for them to manage. The Smiths therefore decide to use the equity in their real estate for a mortgage loan where they make no payments to the bank until 10 years later when the lifespan of the loan ends. Mary and Greg gets a nice lump sum today that they can spend while they are still young and healthy enough to enjoy it, and they don’t have to move out of their home today to utilize its equity.
With some lenders, Mary and Greg could have elected to receive money monthly, quarterly or yearly instead of getting a big one-time lump sum.
With an investment-backed mortgage loan, the borrower is obliged to make regular contributions to an investment plan.
The basic idea with an investment-backed mortgage loan is to have investments that grow throughout the term of the loan. During this time, the borrower makes contributions to the investment plan instead of making payments to the lender.
When the term of the loan is over, the investment-planned will hopefully have created a sum large enough to pay back the loan in full, including interest.
With some investment-backed mortgage loans, the borrower will make regular interest payments to the lender throughout the lifespan of the loan. It is only the repayment of the principal that is deferred until later.
While fixed monthly repayments are normal, making extra payments can yield substantial benefits. It allows you to repay the loan faster and reduce the total cost of the mortgage. Small extra payments can greatly impact the total cost of the loan.