How Does a Mortgage Work? Borrowing Against the Thing You Are Buying
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A mortgage is a loan whose security is the property it buys, which is the arrangement that makes lending hundreds of thousands to someone with no assets possible at all. The lender's protection is that if repayments stop the property can be sold to recover the debt, and almost every feature of the product follows from managing that risk over twenty-five years or more.
What the repayment is made of
A repayment mortgage is calculated so that a fixed monthly payment clears both the interest and the whole capital by the end of the term. Because interest is charged on the outstanding balance, the composition of that fixed payment shifts continuously: in the early years almost all of it is interest and very little reduces the debt, and towards the end almost all of it reduces the debt. That is why a borrower five years into a twenty-five year term has paid a great deal and owes almost as much as they started with, and why overpaying early saves far more than overpaying late, since every pound of capital removed early avoids interest for the entire remaining term. An interest-only mortgage pays the interest and nothing else, leaving the full capital outstanding at the end and requiring a separate plan to repay it, an arrangement that caused widespread problems where the repayment vehicle underperformed. The term length trades monthly affordability against total interest paid, and extending a term reduces the payment while increasing the total cost substantially.
The variables that decide the offer
Lenders assess several things and each affects the rate offered or whether an offer is made at all:
- •The loan to value ratio, meaning the loan as a proportion of the property's value, which determines how much the price could fall before the security is inadequate, and which is why larger deposits secure lower rates in distinct bands
- •Income and affordability, tested not only at the current rate but at a stressed higher rate, which regulators imposed after lending standards collapsed before 2008
- •Credit history, which predicts the probability of missed payments
- •The property itself, since lenders decline unusual construction, short leases and properties with defects, because the security must be readily saleable
- •Whether the rate is fixed for a period or tracks a reference rate, which allocates interest rate risk between borrower and lender
- •Early repayment charges, which compensate a lender for funding arranged against an expected term
Fixed, variable and what breaks
The division of interest rate risk shapes entire national housing markets. In much of Europe and in the United Kingdom, fixed rates last two to ten years and then revert, so borrowers face repricing repeatedly over the life of the loan, which transmits central bank decisions into household budgets within a few years. In the United States the thirty-year fixed rate mortgage is standard, insulating existing borrowers completely and producing a lock-in effect in which people with cheap old loans avoid moving, which reduces housing market fluidity when rates rise. Elsewhere, variable rates dominate and transmission is almost immediate. The failure modes are well documented. Negative equity occurs when prices fall below the outstanding balance, trapping owners who cannot sell without crystallising a loss. Repossession follows sustained arrears and is a loss for both sides, which is why lenders generally prefer forbearance. Systemic failure occurred in 2007 and 2008 when loans made on inadequate assessment were packaged into securities whose risk was misrepresented, and the resulting losses spread far beyond housing.
What it does to housing
The availability and cost of mortgage credit is one of the strongest determinants of house prices, because most buyers purchase with borrowed money and are constrained by what they can borrow rather than by what they have. Cheaper credit raises what people can bid, which raises prices, which means the benefit of lower rates is capitalised into the price rather than making housing cheaper. That mechanism explains a persistent puzzle for policy: measures that help buyers borrow more, including guarantee schemes and subsidised deposits, tend to raise prices and therefore help sellers rather than buyers, while measures that increase supply lower prices and are politically harder because existing owners hold the asset that would fall. Mortgage interest relief, where it exists, has similar effects. The distributional consequence is substantial, since owners gain from rising prices and non-owners face higher entry costs, which is why the age at which people first buy has risen markedly in many countries and why inherited deposits have become a major determinant of who becomes an owner at all.
The takeaway
A mortgage secures a loan against the property being bought, which is why such large sums can be lent to people without assets. A repayment mortgage clears interest and capital with a fixed payment, and because interest is charged on the balance, early payments are mostly interest, so overpaying early saves far more than overpaying late. Loan to value bands, stressed affordability tests and the property's saleability decide the offer. Cheaper credit mostly raises prices rather than making housing more affordable.