How a mortgage works, from lien to payment

A mortgage is a loan used to buy or refinance real property, with the property itself pledged as security for the debt. In the United States two documents do that job. The promissory note is the debt: it names the amount borrowed, the rate and the schedule. The mortgage, called a deed of trust in many states, is the security: it grants the lender a lien over the property. People say mortgage for the whole arrangement, but the note is what you owe and the lien is what the lender can act on. Other countries reach the same result with one instrument rather than two, a registered charge in England and Wales and a standard security in Scotland, and the American pair is the one used below.

A lien is a legal claim attached to one specific asset. While it stands, the property cannot be sold with clear title until the debt is settled, and if the borrower stops paying, the lender can force a sale through foreclosure and take the proceeds up to what it is owed. Whether that runs through a court or through a trustee, and what happens when a sale raises less than the debt, is set by state law: some states treat a purchase-money mortgage as non-recourse, so the lender's claim stops at the property, while others let it pursue the borrower for the shortfall.

That security is why a mortgage carries the lowest rate of any large loan most households can get. A lender facing default on an unsecured debt has a claim against a person. A secured lender has a claim against a specific asset it can sell. Property pledged that way is collateral, and a secured loan prices below an unsecured one for that reason before any other. Security is not the only thing in the rate: the term, how deep the market in these loans is and any government guarantee standing behind them move it too. When the last payment clears, the lien is released and the claim ends.

The down payment is the part of the price paid out of your own money. The rest is borrowed, and lenders track that split as loan to value: the loan divided by the property's value. Borrowing $320,000 against a $400,000 house is 80 percent loan to value, and the $80,000 of price not borrowed against is the owner's equity.

Loan to value is a leverage ratio, and it runs in both directions. At 20 percent down, every dollar of your own money controls five dollars of house, so from that opening position any percentage move in the price reaches your equity multiplied by five, whichever way it goes. A 10 percent fall in the price on day one cuts an $80,000 stake to $40,000: the house lost a tenth, the owner lost half. A 10 percent rise moves the stake 50 percent the other way, on the same arithmetic. Debt is fixed in cash and the asset is not, which is the whole of the asymmetry.

That multiple of five describes day one rather than the loan. It is the price divided by the equity, so it climbs as equity shrinks and falls as equity grows: after the 10 percent fall the remaining stake sits on a multiple of nine, and after a 10 percent rise on a multiple closer to four. Five is the number on the day the deal closes, and a loss makes the money still in the house work harder, not safer.

Lenders price for that risk rather than ignore it. In the United States, conventional loans above a threshold loan to value, commonly 80 percent, carry mortgage insurance: the borrower pays it and it protects the lender. The threshold, the cost and the rules for ending it are set by the loan programme and by law rather than by one general rule.

Loan to value then moves from two sides at once: payments cut the loan, and prices move the value either way. Only the first is yours to control, and a fall in prices can raise loan to value faster than years of payments lower it. The same arithmetic runs on any asset funded partly by borrowing, which is what a leverage ratio measures.

Only part of a United States mortgage bill repays the loan. The usual bundle is called PITI: principal, interest, taxes and insurance. Principal and interest amortise the debt. Taxes and insurance do not. They are bills owed to other people, collected monthly by the loan servicer and held in an escrow account, sometimes called an impound account, until the property tax and the homeowner's insurance premium fall due. Whether the servicer must do this depends on the loan programme and the loan to value: escrow is compulsory on some government-backed loans and on conventional loans above the mortgage insurance threshold, and can often be declined by a borrower with a large down payment.

Escrow exists because the lender's security is the house. An unpaid property tax bill can become a lien ranking ahead of the lender's own, and an uninsured house that burns down leaves nothing to sell. So the servicer collects roughly a twelfth of the expected annual cost each month and pays the bills itself. Once a year it runs an escrow analysis, compares what it collected against what it actually paid, and resets the monthly figure, collecting any shortage and refunding any surplus. How large a cushion it may hold is set by regulation. This is why a payment on a fixed-rate mortgage still changes: the rate is fixed, the tax bill is not.

The consequence is budgetary. Escrow competes with principal and interest inside one monthly limit. Take a lender working to a 43 percent debt-to-income ceiling, a borrower with $6,900 of gross monthly income and $400 of other debt payments. Total debt allowance is $2,967 a month, leaving $2,567 for housing, and $550 of tax and insurance takes that down to $2,017 for the loan. That escrow line is 21.4 percent of the housing budget and it removes 21.4 percent of the loan the same budget would otherwise support. Ceilings vary by lender, programme and country; the arithmetic does not. The debt-to-income calculator works the ratio from the other end.

Nothing in the agreement front-loads the interest. Interest is charged on the balance outstanding, and at the start you still owe nearly all of it, so the interest charge is as large as it will ever be.

On $320,000 at 6.5 percent over 30 years the payment is $2,022.62. Month one charges $1,733.33 of interest, which is 85.7 percent of the payment, and leaves $289.28 to reduce the debt. By payment 60 the interest has fallen to $1,624.75 and the principal share has grown to $397.87, because each dollar removed from the balance permanently removes the interest that dollar was being charged.

Five years in, about 38 percent of the sum borrowed has been handed over and 6.4 percent of the debt has gone. If the house has not moved in price, loan to value has crawled from 80 percent to 74.9 percent. Equity built by repayment alone is slow at first and accelerates later, because the principal share of the payment grows at the loan's own interest rate every month. How amortisation works sets out that schedule payment by payment.

Run the whole term and the totals are large. $320,000 borrowed at 6.5 percent over 30 years is repaid with $728,142.36, of which $408,142.36 is interest, more than the sum borrowed. Read that figure for what it is. It adds up 360 payments in the money of the year each one is made, and sets the total against $320,000 received on day one, so it is not a like-for-like comparison and it is not evidence that the borrower is behind. Discount those same 360 payments back at the loan's own rate and they come to exactly the $320,000 borrowed, which is what a loan priced at its own rate has to do. The interest total is the price of spreading payment over 30 years, quoted in future dollars that 30 years of inflation will have made smaller.

The quoted rate is not the whole price. Closing a mortgage in the United States involves an origination charge, an appraisal, title work, recording fees and often prepaid interest, and some of those are the lender's price rather than a third party's cost. An origination fee charged as a percentage of the loan is priced money, not paperwork.

Discount points are the clearest case. One point is 1 percent of the loan paid at closing to buy a lower rate for the life of the loan. On $320,000 that is $3,200. Suppose it takes the rate from 6.5 percent to 6.25 percent: the payment falls from $2,022.62 to $1,970.30, a saving of $52.32 a month, and total interest over the full term falls from $408,142.36 to $389,306.21, about 4.6 percent less. Divide the cost by the monthly saving and the point has repaid itself after 62 payments, a little over five years.

That is a cash payback, and it leaves two things out. The $3,200 handed over at closing could have been doing something else, which pushes the true break-even later; the cheaper loan also clears its balance a little faster each month, which pulls it earlier. The two work against each other and largely cancel at an opportunity cost near the loan's own rate, which is why the simple division is worth quoting, but it is an approximation rather than an identity.

What the test really turns on is how long the loan is actually held rather than how long it was written for. Selling or refinancing before break-even does not make the points worthless: the lower payment was real from month one, it simply had not added up to the cost yet. How many points buy how much rate varies by lender and by day, so the trade has to be priced each time rather than assumed.

Because fees and rate are exchangeable like this, comparing two offers on rate alone compares nothing. In the United States lenders must disclose an APR beside the note rate, which folds certain financing costs into one annual figure; which costs are included is set by regulation, so an APR is a standardised comparison rather than a complete one. It also spreads those costs over the full term, so it answers the question for a borrower who holds the loan to the end. A borrower who sells in year five paid the same up-front costs over 60 payments instead of 360, and the rate that borrower actually paid is higher than the APR on the sheet.

A fixed-rate mortgage holds one rate for the whole term, so the principal and interest part of the payment never changes and every future payment is known on day one. The payment carries no rate risk; the lender's return does, and the lender prices for that. That is why a 30 year fixed rate is normally quoted above a shorter fixed rate when the yield curve slopes upward, and why an adjustable loan usually opens below the fixed rate offered to the same borrower, though an inverted curve can narrow or reverse that gap. The certainty is bought, not given, and it protects in one direction only: a fixed-rate borrower is left holding an above-market rate if rates later fall, and escaping that means repaying the loan early, which United States loans normally allow without a penalty and loans in many other countries charge for.

An adjustable-rate mortgage fixes the rate for an opening period, then resets it periodically to an index plus a fixed margin written into the note. The index moves with the market; the margin does not. United States naming states both halves: a 5/6 ARM is fixed for five years, then adjusts every six months. The index can fall as well as rise, so a reset can cut the payment as easily as raise it, and the lower opening rate is what the borrower is paid for carrying that uncertainty. Three caps bound the movement, and they are the terms that matter most: how far the rate can move at the first reset, how far at each later one, and how far it can ever go over the life of the loan.

At each reset the lender re-amortises. It solves for the payment that clears the balance you have now, over the term you have left, at the new rate. Take the same $320,000 loan five years in, with $299,555.13 outstanding and 25 years to run. A reset from 6.5 percent to 8.5 percent lifts the payment from $2,022.62 to $2,412.10, about 19 percent, from a 2 percentage point move in the rate.

The fixed and adjustable labels also mean different things in different countries. In the United States a 30 year fixed rate normally means fixed for 30 years. In the United Kingdom a fixed rate usually covers an opening period of two to five years, after which the loan reverts to a variable rate, which is closer to the adjustable structure than to the American fixed loan. The rest of Europe is not one market, and it does not all follow the British pattern: French and Danish loans are commonly fixed for the whole term, while German and Dutch loans fix for ten or twenty years and leave a balance to be refinanced at whatever rate applies by then.