What is a Mortgage and How Does it Work?

Published on December 14, 2016

– 10 min read

For many people, buying a home is the biggest purchase they will make in their lifetime.

With all the different players and factors that go into getting a home loan, getting a mortgage can be stressful. Educating yourself prior to applying can make the process go more smoothly.

At Clara, we take pride in helping anyone who wants to educate themselves about home buying. If the United States learned anything in 2007, it’s that bad loans are bad for everyone. Whether you choose to finance your home with Clara or not, we hope to be a resource for those who are curious about home ownership.

The history of home finance

Some of you might be thinking to yourself “Really? A history lesson?” We think the history of mortgages is fascinating, especially since they are deeply rooted in American history. But we won’t be offended if you skip ahead. If you’re going to have a mortgage, it’s probably a good idea to understand what, exactly, that is. If you learn a little bit about the history of home loans, not only will you come to appreciate the process, but you can impress your friends and new neighbors at your housewarming party.

What is a mortgage?

In plain English, a mortgage is a loan used to buy property. The amount of the loan is usually a fraction of the total property value. To make the loan less risky for the lender, the loan is tied to the property itself – if the loan goes unpaid, the lender typically takes ownership of the property, which they can sell to cover the debt.

    Mortgage – n. – A debt instrument, secured by the collateral of specified real estate property, that the borrower is obliged to pay back with a predetermined set of payments.

Where did mortgages come from?

Mortgages have been around in some form or another for a long time — about 2,000+ years. Buying a home with all cash has apparently always been challenging for people.

Fordham University has some ancient documents from Mesopotamia in their archive which show written mortgage contracts as early as 611 B.C. Our favorite ancient mortgage is this one:

    Contract for Loan of Money, Sixth year of Nebuchadnezzar II, 598 B.C. The rate of interest in this case was thirteen and one-third per cent. One mana of money, a sum belonging to Dan-Marduk, son of Apla, son of the Dagger-wearer, (is loaned) unto Kudurru, son of Iqisha-apla, son of Egibi. Yearly the amount of the mana shall increase its sum by eight shekels of money. Whatever he has in city or country, as much as it may be, is pledged to Dan-Marduk. (The date is) Babylon, Adar fourth, in Nebuchadnezzar’s sixth year.

The best part of this is the guy lending the money was legally referred to as “son of the Dagger-wearer.” Apparently lending money was a family business. How many people have to not pay up before someone earns a name like that?

Prior to the Great Depression, American home loans were hard to come by. Lenders required at least 50% of the purchase price in cash upfront to buy property. (This is called a down payment.) Borrowers would need to save a sizable amount of money to even consider purchasing real estate.

Once a borrower made their 50% down payment, they would only pay the interest on the loan every month. Loans carried variable interest rates, so the monthly payment would fluctuate depending on the market. This made budgeting very difficult for some families because their expenses could change drastically every month. These loans were made over a 5- to 10-year period, and the entire loan amount was due at the end of the term. That means after putting 50% of the price down upfront, the borrower had to pay the other 50% in a lump sum at the end of the loan – and that’s on top of the monthly payments!

Let’s see what these payments would look like with modern home prices. For our example, we’ll use the interest rate from an Illinois bank in 1929:

 
 

 
 

Because of the massive payment due at the end of the loan term, borrowers were basically forced to get a new loan to replace the old one. This is called refinancing a loan. If the borrower didn’t have the cash, and couldn’t refinance, the banks foreclosed – they would seize and sell the home to pay off the debt.

In the early 1930’s, in the heart of the Great Depression, things changed. Like almost every other asset, home values took a nose dive, some declining by as much as 50%. The volatility in the market scared mortgage lenders, making it nearly impossible for borrowers to refinance their debt.

Few borrowers had the cash to cover the loan when it came due, leading to a wave of foreclosures in the U.S. – something like 250,000 homes per year between 1931 and 1935. At its worst, 1 in 10 homes in the U.S. were in foreclosure.

This was the definition of a crisis, so as part of FDR’s New Deal, the government took action. It created three agencies whose goals were to stabilize the markets. (Two of those agencies, FNMA and FHA, still exist today, but we’ll learn more about them
later.)

These new entities bought the mortgage debt from the banks, drastically changed the lengths of the loans so that people could pay them, and then worked with borrowers to help them keep their homes.

These new loans now had fixed rates, longer terms (20 years), and were fully amortized – instead of paying the entire principal balance of the loan at the end of the term, borrowers would pay incrementally over time. These changes not only saved thousands of families from losing their homes, but also made buying homes a much safer endeavor. The modern mortgage was born!

How do mortgages work?

A modern mortgage is actually a piece of paper called the note. Well, a bunch of pieces, but it’s paper nonetheless. It basically states, “The Borrower will pay this money back, otherwise the Lender can take control of the house, sell it, and collect their money.”

A mortgage note, like many other types of debt, can be bought and sold. And because the debt is backed by a physical property, it is considered less risky than some other investments.

To better understand the mortgage process, let’s take a look at a few key players you’ll meet throughout the mortgage process.

Borrowers – That’s you. Or it could be soon. You have your eye on a sweet 2-bedroom, 2-bath house in a great neighborhood, but you don’t have a big pile of cash stuffed in your mattress. To get that house, you’re going to borrow money from someone.

Lenders – That’s us. These are the people or companies that lend you money. Sometimes they’re called “mortgage originators,” which is the fancy way of saying they provide the money for the loan. There are a lot of rules about how a lender can lend money, so these
companies usually follow a highly technical (and highly regulated) process. These can be big banks (like Chase or Wells Fargo), mortgage companies, or in some cases even individual people (like a wealthy family member).

Servicers – Collecting the monthly payments for a mortgage can be complex, especially when managing thousands of mortgages. Lenders often work with companies called “mortgage servicers” to handle the payment collection. These servicers act as middlemen, collecting payment from borrowers and paying it to whomever owns the mortgage debt. A mortgage servicer makes sure the money goes to the right places and the mortgage ends up paid off at the end of the loan.

Investors – Some investors really like the idea of mortgages. They are asset-backed, so they’re less risky, and the interest rate makes them a good investment. However, investors don’t want to deal with the technical process that lenders deal with to lend money out. They also don’t want to worry about collecting that money. They just want to buy the debt instrument (that stack of paper) and collect their money, so they purchase the mortgage note from a mortgage lender.

Agencies – Federal agencies like the Federal Housing Administration, Fannie Mae, and Freddie Mac work as the middle men between lenders and investors. They package loans into groups, called “pools,” and sell those pools to investors. This buying and selling is called the secondary mortgage market.

As a borrower, you will interact with most of these players at some point, so it’s worth having a basic understanding of their roles.

Who gives me my mortgage?

When the time comes, you’ll go to a lender to get a mortgage. This may be your bank, where you hold your checking and savings accounts. Or maybe you’re part of a credit union and go there. It may be an online mortgage lender, like Clara.

Nearly half of homebuyers don’t compare mortgage lenders — which could mean overpaying by thousands of dollars over the life of the loan. But being the financially savvy consumer you are, you will shop around for your loan. Eventually you’ll talk to sales people from these companies.

Loan Officers vary widely. Some are great, knowledgeable, and have your best interests in mind. They’re focused on building long-term customers. Others may not understand the products they’re selling, or they might be more interested in their commission than they are in providing a great service. Researching your mortgage lender, and in some cases your loan officer, is incredibly important. At Clara, our licensed agents are called Loan Specialists. They are trained to keep your best interests in mind and to be your guide through the mortgage process.

If you have any questions, you can chat with one of our licensed Loan Specialists. To see your rates and get pre-approved online, click here.

Steven Fung
Steven Fung is a licensed Loan Specialist at Clara with over 17 years of experience. When he doesn’t have his mortgage hat on, he enjoys repairing old cars and working on home improvement projects.
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