How does a mortgage work?

Mortgages are generally considered to be ‘good debt’ because they can provide you with access to the housing market by allowing you to pay a fixed rate of interest on an appreciating asset. Mortgages are a great tool to enable homeownership. However, as with any type of debt, it’s imperative to avoid overextending yourself.

The popularity of the housing market has resulted in too many consumers overburdening themselves with debt in order to own a home. Before taking out a mortgage, you need to ensure you won’t be taking on any unnecessary stress or risk of default.

Video transcript

Meet Dave and Claire. They are newlyweds wanting to buy their first house. They’ve been saving up. They find the perfect house for $400,000. They have only saved $100,000. What can they do? Where can they get the other $300,000?

What is a mortgage?

They can take out a mortgage with a bank. A mortgage is a loan from the bank. It is a bit different from other loans because the bank uses the house as collateral or security. If you don’t pay back the bank, they can take your house and sell it to get their money back. This is called foreclosure.

How does a mortgage work?

Dave and Claire use their $100,000 for a down payment and borrow $300,000 from the bank, which is their principal loan amount. They will pay a portion of the principal back each and every month until they own the house over an agreed amount of time, usually about 25 years.

The bank will also charge them interest as a cost of borrowing the money. The principal amount they pay will slowly reduce the amount of money they owe the bank and increase their equity on the house. This is called the amoritization. There are different ways to pay down your mortgage. These affect how much it will cost you to borrow the money. The faster you pay your mortgage, the cheaper it will be.

Amortization period

Suppose Dave and Claire pay the house off over 25 years at an interest rate of 5%. They will pay $1,745 a month for 25 years. The total interest they will pay for borrowing this money will be $223,446.

Now, suppose they pay the house off in 10 years. They will have to pay $3,174 a month, but they will only pay $80,934 in interest — which is a lot less. In fact, it’s 64% less in total interest paid.

The shorter the amount of time you pay your mortgage, the higher the monthly payments, but the lower your cost of borrowing.

Interest rates

Another important factor is the interest rate. This is the cost of borrowing money and can change over time.

Suppose Dave and Claire have chosen to pay the mortgage over 25 years with an interest rate of 5%. They are paying $1,745 a month. Now unfortunately for them, the interest rates rise by 2%. They now have to pay $2,101 a month — $356 more. If Dave and Claire haven’t budgeted for this it could be a problem.

Fixed vs. variable rates

When you are agreeing to the terms of your mortgage, you can choose a fixed rate or a variable rate. With a fixed rate, you and the bank agree you will pay the same amount of interest for a predetermined amount of time — typically about five years. With a variable rate, your rate will change depending on the current short-term market interest rate. This means your payment amounts could also vary.

Which type of rate is better for you will depend on the length of your loan, the current interest rate environment and what you feel future interest rates will be. Over time, if all goes according to plan, Dave and Claire will pay off their house. If the value of the house increases and they decide to sell, they will have increased their wealth by buying a house.