How Mortgages Work

Buying a home usually means borrowing most of the purchase price from a lender. That loan, called a mortgage, is repaid over many years and is secured by the property itself. This lesson introduces the basic mechanics so later lessons on loan types and rates make more sense.

What a mortgage is

Because the loan is secured by the home, lenders are generally willing to lend large amounts over long periods, such as 15 or 30 years, at interest rates lower than many unsecured loans.

The pieces of a monthly payment

Most monthly mortgage payments combine several components, often abbreviated as PITI:

• Principal: the portion that reduces the amount you originally borrowed
• Interest: the cost of borrowing, paid to the lender
• Taxes: property taxes, often collected monthly and held until due
• Insurance: homeowners insurance, and sometimes mortgage insurance, collected the same way

Not every loan requires taxes and insurance to be collected monthly; this depends on the lender and loan program.

How amortization works

In the early years of a loan, a larger share of each payment goes toward interest because the outstanding balance is still high. As the balance shrinks, more of each payment goes toward principal. This shift happens gradually over the life of the loan.

Why the loan term matters

The length of the loan, known as the term, affects both the size of monthly payments and the total interest paid. Shorter terms typically have higher monthly payments but lower total interest, while longer terms spread payments out and generally increase total interest paid over time. Later lessons compare common term lengths in more detail.

The escrow account

Many lenders set up an escrow account to collect a portion of property taxes and insurance premiums with each monthly payment, then pay those bills on the borrower's behalf when due. This helps avoid a large annual bill but does not change the total amount owed for taxes and insurance.

Fixed obligations versus variable costs

While principal and interest on a fixed-rate loan stay the same for the life of the loan, property taxes and insurance premiums can change over time, which means your total monthly payment can shift even if your interest rate never does. Reviewing annual escrow statements helps you understand these changes when they occur.

Understanding these basic building blocks, principal, interest, taxes, insurance, and amortization, gives you a foundation for evaluating the loan types, rates, and terms discussed in the rest of this module.