A mortgage is a home loan and functions like other large loans. The lender agrees to issue a loan to the borrower, who pays it back slowly over the term of the loan. The term can vary, but most mortgages are either 15, 20 or 30 years in length (balloon mortgages may be considerably less). Along with the loan, lenders charge interest on the principal, adding to the amount borrowers must pay. This interest rate is how lenders make a profit. The home itself is collateral for the loan.

Types of Mortgages

There are three primary types of mortgages, including many subsets with varying terms. The main three are fixed-rate, variable-rate and balloon mortgages.

Fixed-rate mortgages are the most straightforward: an interest rate applies to the principal every month without changing, until the borrower pays off the loan in full.

Variable-rate mortgages start with a low interest rate. But as the loan progresses, lenders have the option to change the rate, usually increasing it based on an economic index. As the economy grows and interest rates increase in general, the rate grows and requires that the borrower pay more interest. Variable-rate mortgages come with limits on how much a lender can raise the rate at one time and in total.

Balloon mortgages follow payment schedules of 30-year fixed-rate loans. However, they end after three, five or seven years, requiring the borrower to pay off the balance immediately. At this time, borrowers typically refinance, creating a second mortgage to pay off the first.

Application

Borrowers must begin by applying for a mortgage. Some banks will offer pre-qualification for a possible loan or even pre-approval, especially if the borrower has good credit. But the bank doesn’t finalize the mortgage itself until the borrower has a property to use as collateral. The borrower must also present a variety of information to the lender, including income and credit information. Borrowers should apply to multiple lenders to search for the best rates.

Risk

Lenders will examine the mortgage application carefully and adjust for risk. They are very wary of borrowers defaulting on loans. Lenders use tighter credit guidelines since the financial crisis of 2008. They now have several categories borrowers fall into based on their credit ratings and income levels. For more risky borrowers, lenders charge higher interest rates to compensate for the risk they might not repay the loans. Banks may turn down borrowers with low income or doubtful credit; although loans guaranteed by the Federal Housing Administration and co-signed loans remain a possibility.

Down Payments

When a borrower applies for a mortgage, the down payment is the amount of the loan he agrees to pay up front, in cash. Lenders prefer large down payments because this increases their immediate profit and decreases their loss in a default. The borrower benefits from a larger down payment because it leaves a smaller amount to pay on the principal. A good down payment is 20 percent of the principal. Borrowers might also choose a 15 or 10 percent down payment, but may not qualify for the same types of mortgages with the lower amount. Government-subsidized loans have down payment requirements as low as 3 percent to help borrowers with a small amount of saved cash.

Payments and Insurance

There are several requirements for a borrower in the process of getting a mortgage. He will need to purchase homeowner’s insurance on property. Payments are always a priority, so borrowers must never miss one or pay late. For high-risk loans, lenders or government organizations may require mortgage insurance payments on top of the monthly loan payments to protect the lender in case of default. FHA-backed mortgages come with mortgage insurance borrowers must pay. If a borrower chooses a down payment of less than 20 percent of the property price, the lender may require private mortgage insurance regardless of the loan type.