What is a Mortgage?

A mortgage is a loan to finance the purchase of a home, and it is probably the largest debt you'll ever take on.

Your home is the collateral for the loan, which is also a legal contract you sign to promise that you'll pay the debt, with interest and other costs, typically over 15 to 30 years.

If you don't pay the debt, the lender has the right to take back the property and sell it to cover the debt; this is called repossession.

To repay the mortgage debt, you make monthly installments or payments that typically include the principal, interest, taxes and insurance, together known as PITI.

Principal and Interest

Principal: The principal is the sum of money you borrowed to buy your home. Before the principal is financed you can give the lender a sum of cash called a down payment to reduce the amount of money that you borrow.

Interest: Usually expressed as a percentage called the interest rate, interest is what the lender charges you to use the money you borrowed. In addition to the given rate, the lender could also charge you points and additional loan costs. Each point is charged at the rate of one percent of the financed amount and points are financed along with the principal.

Principal and interest comprise the bulk of your monthly payments in a process called amortization, which reduces your debt over a fixed period of time. Each payment includes both an interest payment portion and a principal payment portion. With amortization, the interest payment portion is higher in early years and principal payment portion is higher in later years.

Taxes and Insurance

In addition to your principal and interest, your mortgage payment could include money that's deposited in an escrow or trust account to pay certain taxes and insurance.

Generally, if your down payment is less than 20 percent of the loan, your lender considers your loan riskier than those with larger down payments. (Note that the percent amount varies from place to place – in some places it could be 25 percent in others 20 percent - check with local lenders.) To offset that risk, the lender sets up the escrow account to collect those additional expenses, which are rolled into your monthly mortgage payment.

Taxes: The taxes are property taxes your community levies based on a percentage of the value of your home. The tax is generally used to help finance the cost of running your community, e.g., to build schools, roads, infrastructure and other needs. You must pay property taxes even if you don't need an escrow account and even after your mortgage is paid off.

Insurance: Lenders won't let you close the deal on your home purchase if you don't have home insurance (also called hazard insurance), which covers your home and your personal property against losses from fire, theft, bad weather and other causes. Even if you pay cash for your home, you should buy home insurance unless you can afford to repair or rebuild your home if it's damaged or destroyed.

If your home is in a federally designated high flood risk zone within a flood plain and you are signing for a federally insured loan, federal law mandates that you must buy flood insurance. If you are not in a high flood risk zone, you can still buy the coverage.

If your down payment is less than 20 percent (or the percent amount accepted by lenders) of your home purchase most lenders will also charge you private mortgage insurance (PMI) premiums. The coverage doesn't protect you, it protects the lender from you defaulting on the mortgage. Without the coverage, many buyers could not otherwise afford to buy a home.