What is a mortgage? It seems like a simple enough question, but oftentimes many people seem to be ignorant as to what they are actually agreeing to when accepting a mortgage. Webster's Dictionary defines a mortgage as "a conveyance of or lien against property (as for securing a loan) that becomes void upon payment or performance according to stipulated terms." In simpler terms, a mortgage is an agreement. The bank agrees to lend you an amount of money to purchase a home and you agree to pay that money back, with interest, over a certain period on months (usually 360 months or 30 years). The money that the bank lends you is secured by the home you are purchasing. This means that if you fail to make your monthly mortgage payments as you agreed to do, then the bank can foreclose on your mortgage and take your home away from you.

There are several different types of mortgages designed to offer borrowers a wide range of choices when structuring the terms of their loan. The first and most common type of mortgage is a Fixed Rate Mortgage. This mortgage has an interest rate that is fixed (remains the same) for the entire length of the loan (usually 15 or 30 years). This type of mortgage will allow the most stability for the borrower as their monthly mortgage will always be the same. The majority of home buyers will use a fixed rate mortgage.

A second type of mortgage is known as an Adjustable Rate Mortgage (ARM). This mortgage has an interest rate that adjusts or "recast", meaning that it may increase or decrease depending upon what is going on in the financial market. These adjustments will occur at set points in time over the life of your mortgage, sometimes as often as every month, but more often every 6 or 12 months. An ARM will give a borrower a better starting interest rate than a fixed rate mortgage however it also offers less stability as the interest rate has the potential to raise higher than that of the fixed rate loan, often by several percent.

A common compromise between the fixed rate mortgage and the ARM is what is known as the Hybrid ARM. This is an adjustable rate mortgage where the starting interest rate is fixed for the first 2, 3, 5, 7, or 10 years and then adjusts either every 6 or 12 months thereafter. These ARMs are often referred to as 2/28, 3/1, or 5/6 ARMs. The numbers in these designations refer to the terms of the adjustments. For example, a 2/28 ARM is fixed for the first two years, adjust one time, and remains at the new adjusted rate for the remaining 28 years of the loan. A 3/1 ARM would have a fixed rate for the first 3 years and then adjust every 12 months (or 1 year) thereafter. Finally, a 5/6 ARM will have a fixed rate for the first 5 years and then adjust every 6 months after that. These types of ARMs can offer a borrower short term stability while also providing them with a lower starting rate than a normal fixed rate mortgage. They are ideal for borrowers who will not remain in a home for more than a few years.

Lastly there are Interest Only Mortgages. These mortgages can be fixed rate or ARMs and will have an extra monthly payment option. You can chose to pay the normal principal and interest mortgage payment or you can chose to pay only the interest on that month's payment. This payment option can last for up to the first 10 years of your loan, depending upon the lender who you use. There are a few variations on this type of mortgage, including the Option ARM, which has received a lot of press these last few years. All types of Interest Only mortgages are designed for one reason. They are meant to give a money savvy home owner the ability to free up some extra cash from month to month to spend on other investments. These mortgages are not designed to allow a borrower to purchase more home than they can afford, although that is exactly how they have been misused over the last few years.

Each of the types of mortgages listed above has its pros and its cons. Understanding the differences between them is essential to getting the mortgage that is right for you and your situation.

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