What is Mortgage? | Definition, Types, Advantages vs Disadvantages

The term ‘mortgage’ is sometimes used interchangeably with ‘collateral’, referring to an individual’s property or real estate assets against which one takes out a loan. The concept of the mortgage ensures that the borrower remains obligated to pay off the loan and the interest accrued in regular instalments.

A mortgage may also refer to a common financial practice in purchasing real estate in which the buyer does not pay the entire amount in one go. Loans and interests will be paid until the entire sum has been paid and the individual gains ownership of the house or establishment.

Key Takeaways

1. A mortgage is a loan used to purchase a property or real estate, with the property serving as collateral for the loan.
2. Mortgages have a fixed interest rate and a set repayment term, with monthly principal and interest payments.
3. Failure to make mortgage payments can result in foreclosure, where the lender can take possession of the property and sell it to recover their investment.

Why are mortgages necessary?

1. It is necessary for the lender’s security (a bank). Upon inability to meet the required number of payments or in case of a defaulted loan, the lending authority is empowered to seize the mortgaged asset to avoid losses.
2. Mortgages have a lot of flexibility concerning the number of years before it has to be paid off or the rate of interest (fixed or adjustable). It provides the borrower immediate financial assistance through a loan while buying them enough time to pay it off.
3. Loans against real estate have no restrictions regarding how the loan is used – whether to fund education, a wedding, or emergency expenses. Thus it is a necessary option of collateral that is helpful to the borrower.

Types of mortgages

1. Fixed-rate – The borrower must pay the same interest rate throughout the tenure, and the monthly instalments do not differ from the first to the final one.
2. Adjustable rate – In this case, the interest rates remain constant for a certain period, which fluctuates according to market rates. Thus, the borrower may pay more in the long run than they had initially.

Advantages of a mortgage

1. You can reduce your total annual payments significantly by writing off mortgage interests. This feature does not reduce the amounts due in instalments but can reduce the payable income tax to a significant degree.
2. It is impossible for people to buy real estate for cash upfront. Mortgages enable you to buy a house without paying the entire amount immediately.
3. Long-term mortgages have lower interest rates, making it easier on the borrower.

Disadvantages of a mortgage

1. The burden of debt can generate a great amount of financial distress. In families of certain socioeconomic backgrounds, this requires them not only to cut back on certain expenditures but also to compromise their standard of living.
2. If your property is mortgaged for a significant amount of time (15 to 30 years), it hampers other financial decisions and one’s ability to secure another major loan.
3. Due to changing market rates, the property’s value may change over the years. This has other undesirable implications for the loan taken.

References

1. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1551227
2. https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1538-4616.2011.00391.x