What is a mortgage and what makes it different than any other loan?

January 14, 2013, 04:59:00 PM EDT


Owning your own home has been a key part of the traditional American Dream for more than half a century, since the rise of suburbia in the 1950s. The world has changed a lot since then, but owning a home still hold tremendous meaning to people around the country. And whenever people start talking about buying a house, finding a way to pay for it is bound to come up.

Even a relatively modest ranch-style house can run upwards of a half-a-million dollars, and not many people can afford to shell out that kind of cash on the spot. At the same time, most people also can't borrow that kind of money just on a good track record of paying bills on-time, which is where the mortgage loan comes in.

Often these loans are known simply as mortgages, but that term technically refers to the real estate that is put on the line as collateral for the loan - in this case, the house itself.



Borrowing on collateral
It might not seem like it, but this idea of using the property being purchased with a loan to back up the credit of the borrower was actually a major innovation in the early parts of the 20th century. Prior to that, buying a home was much less common and far fewer Americans actually owned their own property.

And it really is a significant deviation from the traditional model for lending. Even today, traditional loans are doled out on the basis of a credit score or a detailed background check, depending on the size of the loan. The lender is taking the risk that you will ultimately be able to pay back what you owe, and your legal obligations provide the only real assurances.

Mortgages, on the other hand, leave ownership of a home or other real estate at least partly in the hands of the lender until such time as the loan is paid off. This process can take decades to complete, with many mortgages running for as long as 30 years.

When a new "homeowner" first agrees to their mortgage and moves into their house, the proportion of their home's equity - ownership rights - that they hold depends upon the size of the down payment they chose to make. In many cases, banks will not cover more than 80 percent of the costs of purchasing a home, requiring borrowers to put forward a still significant amount of cash up-front, though also giving them a greater ownership stake in the home. Some lenders will finance a much greater proportion of the home, but this ultimately results in higher costs for borrowers.



Paying by parts
But even with the size of the down payment aside, it still generally takes some time to increase your equity in your home.

All loans are split between the principal (the original amount of the loan), the interest (whatever you pay the bank for its services), the taxes (which are often included in loan payments and set aside by the lender) and the insurance (which most mortgages require as a protection both for you and for the lender's investment) - what is generally known by the acronym PITI.

Mortgages are usually structured so that you are primarily paying off the interest first, so that banks retain ownership of the property throughout most of term of the loan.

On top of the costs inherent to the loan itself, mortgages are also distinguished from traditional loans by the variety of fees borrowers must pay throughout the application process. Simply applying for a mortgage itself incurs a fee to cover the lender's costs for the process, which can include further fees for credit checks, inspection of the property, applying for mortgage insurance, providing a final valuation and much more.

These fees, most of them collectively referred to as closing costs, can add thousands of dollars to the ultimate cost of the loan above and beyond what borrowers are already paying in interest.



What is the mortgage market like?

With so many Americans looking to own their own homes over the past several decades, an enormous market emerged to fill the financing needs of the country. Most of the country's largest banks have large investments in real estate, and many other financial and governmental institutions ranging from credit unions to some investment funds also offer mortgages.

Over the course of the late 20th and early 21st centuries, the market for homes heated up along with the economy, leading financial institutions to create a variety of complex loan products designed to cater to borrowers with increasingly questionable credit - what has come to be known as the rise of the subprime mortgage.

These loans then got packaged and traded around between firms, often inflating in price and masquerading as more reliable forms of debt, until finally the bubble burst and some of the worst loans started to go bad. This left banks and other institutions with decreasingly valuable properties that they were then unable to sell, for lack of buyers with sufficient credit.

The resulting collapse in the marketplace in 2007 and 2008 led not only to a massive recession, the largest financial crisis since the Great Depression, but also to a major restructuring of mortgage industry.

A growing number of institutions have backed away from mortgage markets, reducing the number of available lenders significantly from the early part of the new millennium. There are also often higher borrowing costs and more demanding application processes than there ever were during those years.

However, despite ongoing nervousness about investing in U.S. mortgage-backed securities, the market for borrowers themselves has improved dramatically since the first years after the crisis. The biggest difference is largely a retreat from the riskier loans to less creditworthy borrowers, as those with solid financial standing can once again more readily to find financing.