A mortgage can be defined as a contract whereby a debtor leaves a property as collateral to a creditor, who is making a loan to the debtor. Thus, if the debtor fails to pay his debt, the creditor may request the sale of the mortgaged property in order to collect what is owed to him.
In other words, a mortgage is a debt instrument that allows the creditor a security interest in your loan. As a result, it uses the property mortgaged by the debtor as collateral.
Commonly these terms are often confused, because although they may sound alike, they are completely different concepts:
1.While mortgages are a security interest, which functions as an insurance that the debtor will pay his debt to the bank. Otherwise, the creditor will have the right to bid for the sale of the property in order to recover the amount loaned.
On the other hand, the mortgage loan consists of the creditor lending an amount of money to the debtor. The debtor must repay the amount over a period of time, and will have to pay interest on the loan.
The amount you borrow with your mortgage is known as the principal. Each month, a portion of your monthly payment will go to pay that principal, or mortgage balance, and a portion will go to interest on the loan. Interest is what the lender charges you for lending you money.
Most people’s monthly payments also include additional amounts for taxes and insurance.
The part of your payment that goes to principal reduces the amount you owe on the loan and builds your equity. The interest portion of your payment does not reduce your balance or build your equity. Therefore, the equity you build in your home will be much less than the sum of your monthly payments.
With a regular fixed-rate loan, the combined principal and interest payment will not change during the term of your loan, but the amounts that go to principal instead of interest will change. Here’s how it works:
At first, you owe more interest, because your loan balance is still high. So most of your monthly payment goes to pay the interest, and only a little goes to pay the principal. Over time, as you pay down the principal, you owe less interest each month, because your loan balance is lower. Thus, more of your monthly payment goes to pay down the principal. Near the end of the loan, you owe much less interest, and more of your payment goes to pay off the last of the principal. This process is known as amortization.
Lenders use a standard formula to calculate the monthly payment that allows a certain amount to go toward interest versus principal in order to pay off the loan precisely at the end of the term.