What Are the Parts of a Mortgage Loan?
Gain clarity on the essential financial, practical, and legal components that constitute your mortgage agreement.
A mortgage loan allows individuals to purchase a home by borrowing funds, with the property itself serving as collateral for the debt. This financial arrangement makes homeownership accessible by spreading the cost of a significant asset over many years. It involves a structured agreement where a lender provides capital, and the borrower commits to regular repayments over a set period.
The Core Financial Elements
The principal represents the actual amount of money borrowed from the lender to purchase the home. Each payment made by the borrower gradually reduces this outstanding balance.
Interest is the cost of borrowing the principal amount, calculated as a percentage of the remaining loan balance. Lenders charge interest to compensate for the risk and the time value of money. The interest rate can be fixed, meaning it remains constant for the entire loan term, or adjustable, meaning it can change periodically based on market conditions.
Amortization is the process by which loan payments are applied to both principal and interest over the loan’s term. In the early years of a mortgage, a larger portion of each payment typically goes towards paying the accrued interest. As the loan matures, and the principal balance decreases, a greater share of each payment is then applied to reduce the principal.
The Escrow Account
An escrow account is a special account managed by the mortgage servicer on behalf of the homeowner. Funds are deposited into this account monthly as part of the total mortgage payment. The purpose of this account is to collect and hold money for certain property-related expenses that are not directly part of the loan’s principal and interest.
One primary component typically collected through escrow is property taxes. By collecting a portion of the estimated annual tax bill with each monthly mortgage payment, the lender ensures that sufficient funds are available to pay these taxes when they become due. The mortgage servicer then disburses the lump sum payment to the taxing authority on the homeowner’s behalf.
Homeowner’s insurance premiums are another common expense managed through an escrow account. This insurance protects the property from damage. The lender requires adequate insurance coverage to protect their financial interest in the property. Similar to property taxes, a portion of the annual insurance premium is collected monthly and held in escrow, allowing the servicer to pay the insurance company when the premium is due.
From the lender’s perspective, managing these payments through escrow helps safeguard their investment by ensuring that property taxes are paid, preventing tax liens, and that the property remains insured. For the borrower, it offers a convenient way to budget for these significant annual expenses by spreading them out over 12 monthly installments.
The Essential Legal Documents
The promissory note is a fundamental legal document in a mortgage transaction, representing the borrower’s written promise to repay the borrowed money. It details the specific terms of the loan, including the original loan amount, the interest rate, the schedule of payments, and the maturity date. This document serves as the evidence of the debt and outlining the borrower’s personal liability to repay the funds.
Alongside the promissory note, either a mortgage or a deed of trust serves as the security instrument for the loan. This document creates a lien on the property, granting the lender the right to take possession of the property through foreclosure if the borrower fails to meet the terms of the promissory note. While both serve the same purpose of securing the loan with the property, the specific document used depends on the legal practices in different jurisdictions.
A mortgage is commonly used in some states, directly creating a lien on the property in favor of the lender. In other states, a deed of trust is employed, which involves three parties: the borrower, the lender, and a neutral third party known as a trustee. In a deed of trust arrangement, the borrower transfers legal title to the trustee, who holds it until the loan is fully repaid or until default occurs.