Don’t worry, it’s not a silly question!
There are certain bits and pieces of knowledge that we take for granted. Everyone kind of knows what a mortgage is, but it’s okay if you don’t understand the more intricate details of a mortgage or how a mortgage works. What is a mortgage? Good question! It would be easy to simply say that a mortgage is a loan, but there’s a lot more to it than that.
Our objective today is to help you understand what a mortgage is, who they’re for, when they’re useful, how they’re different from other types of loans, the various types of mortgages, how to find the right mortgage, and a few other basic things you should know about the early stages of the investment properties process. Sounds good? Let’s get right into it.
What is a mortgage and how does it work?
This is a good place to start. A mortgage is a loan used to purchase property and land. A mortgage can be used to buy a house, a condo, an apartment building, a patch of land, or even a commercial building. It empowers real estate investors to purchase a place without having all of the cash up front. There are also commercial loans, which we’ll discuss as well, but our primary focus is on using a mortgage to purchase a investment property.
To make a comparison with a type of loan that most consumers are familiar with, let’s compare a mortgage loan to credit card debt.
Credit cards are not secured by any tangible assets so they carry higher interest rates. If somebody is having a tough time financially, or just isn’t very responsible with their spending and ends up racking up a huge credit card debt that they can’t repay, then the lender has limited options when it comes to collecting on the debt. This especially true if the cardholder decides to declare bankruptcy.
A mortgage, on the other hand, is a long-term loan that is backed by the property itself. If worse comes to worst and the investor isn’t able to pay the mortgage, then the property will be repossessed by the bank, which can then sell it. The bank keeps all of the money that has been paid into the mortgage to date and also gains possession of the property. The interest rates are lower for a mortgage than a credit card because the risk to the lender, which is the bank in most cases, is also much lower.
How do mortgages work?
Mortgages are complex, and sometimes it can feel like you need a degree in advanced mathematics just to fully comprehend what you’re getting yourself into. This is why it’s so important to do your initial research in order to understand the basic formulas that will determine how much you’ll end up paying over the life of your mortgage and to avoid many common mistakes.
Once you start to understand the basics, the whole picture becomes much more clear.
What is the difference between a loan and a mortgage?
A mortgage is a type of loan, so in that sense, there is no difference between a loan and a mortgage. It’s like asking what is the difference between an apple and a fruit? An apple is a type of fruit. Granted, there are plenty of differences between mortgages and other specific types of loans, as we discussed in the above credit card example.
What does mortgage really mean?
To put it in more abstract terms, a mortgage is a long-term commitment you’re making to live in the same place (or to rent it out as an income property) and to make monthly payments, no matter what. A mortgage can save you money compared to renting because you’re cutting out one of the middle-men. In this case, it’s the landlord.
A landlord will use a mortgage to buy a property and then they’ll rent that property out at a monthly price that’s higher than their mortgage payment. When you, as an investor, take out a mortgage directly, you’re saving the difference—bearing in mind that you’re now responsible for things like property taxes and repairs.
What are the types of mortgages?
A residential mortgage: This is the most common type of mortgage. It’s what an individual uses to purchase their real estate investments. Residential mortgages can be used to buy a house, a condo, a townhouse, and other types of investment properties that you can own. It allows you to pay a monthly rate for real estate investments rather than paying money to a landlord in the form of rent.
A commercial mortgage: This type of mortgage is quite similar to a residential mortgage. However, it is used for a commercial property instead of residential. Simple enough, right? We’ve covered the topic of “What is a commercial mortgage?” in much greater depth, so please refer to that page if you’re looking for more information. Commercial mortgages can be used to finance the purchase of assets such as office buildings, a commercial plaza, a storefront, a storefront with apartments, etc.
What is an open mortgage?
An open mortgage grants you the ability to pay off the rest of your mortgage at any point without incurring any penalties. If you come across a large sum of money and want to avoid paying any more interest on your investment property’s mortgage, then an open mortgage will allow you to do that. It will also allow you to make larger payments along the way if you choose. Additionally, it generally grants more freedom.
This comes at a cost, though. You’ll typically have to pay higher interest rates on an open mortgage because the lender wants to ensure they’re still making enough money throughout the life of the loan. If you pay it off early, then they are not earning as much interest, so they use a higher rate to help compensate for that.
What is a closed mortgage?
A closed mortgage has rules that dictate your ability to make additional payments or to pay off your mortgage early. You will likely face steep penalties for trying to pay off your mortgage early because you’ll have had a lower interest rate than an open mortgage. In addition, if you could pay it off without penalties, then you would be having the best of both worlds. If you plan to make any additional payments or to pay off your mortgage early, then it’s probably a better idea to strongly consider an open mortgage.
Nonetheless, you can still make extra payments, in many cases, with a closed mortgage. There will be limits on these additional payments and penalties for exceeding those limits, so make sure you’re careful about it. Making extra payments here and there can have a profound impact on the compounding effect of interest over time, but if you go past the limits and incur penalties, then those benefits are quickly erased.
What is a fixed-rate mortgage?
This is a type of traditional mortgage where the interest rate you pay is fixed until the maturity date. You’ll still need to negotiate a new rate at the end of your term, but you are removed from the monthly or yearly fluctuations in the market and you pay a small premium for this potential benefit. If rates go down during your term, then you are still locked in at a higher rate. If rates go up, then you benefit by continuing to pay your lower locked-in rate.
What is a variable rate mortgage?
To put it simply, a variable rate mortgage is when the rate is not fixed.
With a variable rate mortgage, your monthly payments will stay the same—regardless of changes to the market, so it’s just as easy to budget your monthly expenses whether you have a fixed rate or a variable rate.
Fluctuations in interest rates will determine the portion of each payment that goes towards interest or the principal amount of your loan. When a greater amount of your mortgage payment is going towards interest, it will take longer to pay off the principal.
What is an adjustable-rate mortgage?
An adjustable-rate means that the total that you owe with each mortgage payment will fluctuate along with the interest rates. Unlike variable mortgage rates or fixed rates, you can’t expect to pay the same amount each month. This can benefit you when interest rates are lower, but punish you when they get higher.
How does one budget for their monthly mortgage payment?
If you’re used to paying rent, then budgeting a monthly mortgage payment is already something you’re familiar with more or less. The difference is that there are additional costs associated with real estate investments. These include property taxes, repair bills, maintenance, and other things that a landlord would typically be responsible for. If you don’t have a lot of extra spending money each month after paying rent, then you’ll want to look for a mortgage that’s going to cost you less than your previous rent. Put the extra money away each month for repairs, taxes, insurance, etc.
What are some important definitions?
Here are some words and concepts which you’ll often find associated with mortgages. These mortgage definition words will appear commonly while researching and choosing a mortgage.
Amortization period: Unlike the maturity date, the amortization period represents the entire length of mortgage loans from the first few mortgage payments until you have paid it off entirely.
Down payment: You are required to make an initial payment based on a percentage of the amount of your mortgage. It can vary depending on many factors, but 10% to 20% is common.
Payment schedule: This schedule determines how often your payments are due. Monthly payments are the most common, but more frequent payments can result in you paying less in interest throughout the term of your mortgage.
Maturity date: This date represents the end of the term of your mortgage. You’ll have the option to pay off the remaining balance owed or to re-negotiate based on current interest rates.
Credit score: This number is used to determine your creditworthiness or, in other words, the perceived risk a lender takes on by lending you money. A lower credit score means that you are seen as a higher risk of default on your payments.
Interest: The interest on your mortgage is the amount you must pay in exchange for the service of borrowing money—as determined by your interest rate. This is the cost you incur on top of the actual price of the investment property.
Are you ready to take the next step?
Once you have a good understanding of what a mortgage is and how a mortgage works, then you are ready to start taking the next steps towards real estate investments. It’s normal to feel overwhelmed throughout the whole process, but by breaking it down into smaller pieces, you’re well on your way to signing that offer and getting the keys to your new investment.
These steps include shopping around for the best mortgage rates, deciding between using a bank versus a mortgage broker, figuring out how much you can afford to spend on an investment property, and more. We’re here to help guide you towards the best mortgage rates while offering realistic and practical advice along the way.