Understanding Mortgages: This Is How They Work

Are you ready to take out a mortgage?

For most of us, our mortgage is the largest financial decision we make in our lives. But when it comes to understanding mortgages, there are several things you should know.

But don’t worry, we are here to help! Read on for our guide to mortgages, how they work, and the terminology you should know.

What Is a Mortgage?

A mortgage, is a loan to buy a property as well as a contractual agreement between the borrower and the lender.

The lender agrees to loan the money to the borrower to buy the property. The borrower agrees to pay it back with interest over a set period of time.

For most people, a mortgage is essential for purchasing a property. But if the borrower defaults on the loan (fails to make payment), the lender can reclaim the property and sell it on. Only once the borrower pays off the mortgage is full ownership theirs.

Before qualifying for a loan, there will be eligibility requirements to meet. These can differ between lenders. Most likely, an approved person will have a stable income and a debt-to-income ratio of under 50%. They’ll have a fair credit score, usually over 620 or above.

What Are the Important Bits?

There are a lot of documents to sign when you get a mortgage. This includes promissory notes and deeds of trust in a lot of states.

Promissory Note

The promissory note (often called “note”) outlines how you’ll repay the loan. It will include the following details:

  • loan amount
  • interest rate
  • loan term (30 or 15 years for example)
  • when the contract considers the loan late
  • what the interest and the principal payment is


The term mortgage is often used as the term for the whole loan but it has a specific meaning. The mortgage is the document that gives the lender the right to take ownership of your property if you fail to pay. If you default on those agreements in the note, the bank will take back your home and resell it.

Deed of Trust

Most mortgages will be an agreement between two parties. This will be you (the borrower) and your mortgage provider (the lender). In some states, you may need a third party (the trustee). They’re added in via a trust of deed.

Mortgage Terms

There are different mortgage terms that you’ll encounter during the process. Here are a few common terms that you’ll come across and what they mean. It is recommended that you hire mortgage professionals like Union Home Mortgage to help you through the process and advise you on the best mortgage type for your situation.

Down Payment

The down payment is the money you’ll pay upfront before buying your home. In most cases, you need to put a down payment before you can get a mortgage.

Conventional loans can ask for as little as 3% of the house price. With these options, you’ll need to pay a monthly fee called private mortgage insurance. This is to compensate for the small down payment.

But, if you put down 20%, you’re likely to get a better interest rate. You wouldn’t have to pay for private mortgage insurance either. A mortgage calculator will let you see how your down payment amount will affect your terms.

Fixed-Rate Mortgage

With fixed-rate mortgages, the interest rate is set when you take out the mortgage. It won’t change over the lifetime of your contract. This option offers more stability for long term payments.

Adjustable-Rate Mortgage

An ARM uses an interest rate that ties to a margin and an index. When this index goes up or down, your payment will go up or down with it. This index is a measure of international interest rates

These indexes will make up the variable part of your ARM. They will go up or down depending on various factors. These include the strength of the economy or whether the Federal Reserve is putting rates up or down.

A lot of ARMs start off with a lower interest rate than fixed mortgages. They’ll lock this rate in for a set number of years. In the early years of the loan, this can mean your payments are quite a bit lower.

But you need to keep in mind that your situation might change before your rate adjustments. Anything could happen from:

  • Your financial situation changing
  • Interest rates rising
  • The value of your property goes down

You might not be able to sell your home. And you might struggle to meet the higher payment rates that come with higher interest rates.

Mortgage Repayments

There are many things that go into making up your monthly mortgage payment. On top of the interest, the principal, and anything your APR covers, you’ll have taxes. There may be homeowner’s insurance and mortgage insurance as well.
These are separate from fees and costs in your APR. We’ll explore some in more detail below.


You’ll usually have a choice to pay property taxes on their own or as part of your mortgage payments. When paid with your mortgage payment, the money goes into an escrow account.

It will sit there until the tax bill for your property is due. The lender then pays the proper amount of tax out of that account when that time comes.

Homeowner’s Insurance

This is insurance covers your home against fire damage, accidents, and other issues. Some lenders will demand you have insurance included in your monthly payments. Others will let you pay it separate from this.

Like property tax, if you’re paying it as part of your monthly payments, it’ll go into an escrow account. The lender will then use it to pay the insurance when it comes due.

Mortgage Insurance

Some mortgage types need you to pay private mortgage insurance or PMI. This usually is the case if you don’t hit the 20% down payment mark. It remains the case until the loan-to-value ratio hits 78% or lower.

PMI backs up the loan and will protect the lender from the increased risk. They stand to lose more if the borrow defaults on these loans with lower down payments.

Understanding Mortgages

As you can see, there is a lot to know when it comes to understanding mortgages. There are so many options that a bad mortgage decision could have a big impact on your finances. But by doing your research you should be able to find the perfect mortgage to suit your needs.

If you found this article useful, be sure to check out our other posts.