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What is a mortgage?
A mortgage is a method of using property as security for the payment of a debt.
Technically the term mortgage (from Law French, lit. "dead pledge") refers to the legal device used in securing the property, but it is also commonly used to refer to the debt secured by the mortgage.
In most jurisdictions mortgages are strongly associated with loans secured on real estate rather than other property (such as ships) and in some cases only land may be mortgaged. Arranging a mortgage is seen as the standard method by which individuals or businesses can purchase residential or commercial real estate without the need to pay the full value immediately.
In many countries it is normal for home purchase to be funded by a mortgage. In countries where the demand for home ownership is highest, strong domestic markets have developed; notably in Great Britain, Spain & USA.
Repaying the mortgage
There are various ways to repay a mortgage loan depending on your locality, tax laws and prevailing culture.
Mortgage & interest
The most common way to repay a loan is make regular payments of the mortgage and interest over a set term. This is commonly referred to as (self) amortization in the US and as a repayment mortgage in the UK. Depending on the size of the loan and the prevailing practise in the country the term may be short (10 years) or long (50 years plus). In the UK and US 25 to 30 years is typical. Mortgage repayments, which are typically made monthly, contain a capital element and an interest element. The amount of capital included in each repayment varies throughout the term of the mortgage. In the early years the repayments are largely interest and a small part capital. Towards the end of the mortgage the repayments are mostly capital and a small part interest. In this way the repayment amount determined at outset is calculated to ensure the loan is repaid at a specified period in the future. This gives borrowers assurance that by maintaining repayment the loan will definitely be cleared at a specified date.
Interest only
The main alternative to capital and interest mortgage is an interest only mortgage where the capital is not repaid throughout the term. This type of mortgage is common in the UK especially when associated with a regular investment plan. With this arrangement a regular contributions are made to a separate investment plan designed to build up a lump sum to repay the mortgage at maturity. This type of arrangement is called an investment-backed mortgage or is often related to the type of plan used: endowment mortgage if an endowment policy is used, similarly a PEP mortgage, ISA mortgage or pension mortgage. Historically investment-backed mortgages offered various tax advantages over repayment mortgages although this is no longer the case in the UK. Investment-backed mortgages are seen as higher risk as they are dependedent on the investment making sufficient return to clear the debt.
It is not uncommon for interest only mortgage to be arranged without a repayment vehicle with the borrower gambling that the property market will rise sufficiently for the loan to be repaid by trading down at retirement or for other less well thought-out reasons.
No capital or interest
For older borrowers (typically in retirement) it is possible to arrange a mortgage where neither the capital nor interest is repaid. The interest is rolled up with the capital increasing the debt each year.
These arrangements are variously called reverse mortgages, lifetime mortgages or equity release mortgages in different countries. The loans are typically not repaid until the borrowers die, hence the age restriction. For further details see equity release.
Interest and partial capital
In the US a partial amortization or balloon loan is one where the amount of monthly payments due are calculated (amortized) over a certain term, but the outstanding capital balance is due at some point short of that term. In the UK a part repayment mortgage is quite common especially where the original mortgage was investment-backed and on moving house further borrowing is arranged on a capital & interest (repayment) basis.
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