How a mortgage actually works
A loan secured on a house, repaid on a schedule that is front-loaded with interest. The structure explains most of what surprises people.
A mortgage is a loan secured against a property. If you stop paying, the lender can take the house. That security is why mortgage rates are lower than unsecured borrowing.
Amortisation, and why early payments feel useless
The monthly payment is fixed, but its composition is not. Interest is charged on the outstanding balance, which is largest at the start. So early payments are mostly interest and barely reduce the debt; later payments are mostly principal.
On a loan of $300,000 at 6% over 30 years, the first monthly payment is roughly $1,799, of which about $1,500 is interest and about $299 reduces the balance. By the final years that ratio is reversed. These figures are arithmetic on assumed inputs and describe no real mortgage offer.
This is why five years into a long mortgage the balance looks stubbornly close to where it started, and why people conclude something is wrong. Nothing is wrong; that is the structure.
Fixed and variable
- Fixed. The rate is locked for a period. Certainty, usually at a slightly higher starting rate.
- Variable. The rate moves with a reference rate. Cheaper sometimes, and the payment can rise.
A fixed rate does not always mean fixed forever — US mortgages are usually fixed for the whole term, but in many other markets (and on US adjustable-rate loans) the rate is fixed for a period and then resets, which is a future event worth knowing the date of.
What overpayment does
Because interest accrues on the outstanding balance, a lump sum early removes interest from every subsequent month. The saving is far larger than the sum itself, and larger the earlier it is made. Lenders may cap annual overpayments, and that cap is in the contract.
The rate it follows
Fixed mortgage rates track long-dated government bond yields much more closely than they track a central bank's overnight rate. This is why a rate cut does not automatically make a fixed mortgage cheaper. See Treasury yields and the curve.