A mortgage is a long term loan that is designed to assist the borrower in purchasing a home. Just like any loan from a lender, or credit card account, in addition to paying the “principal”, the borrower must also make interest payments to the lender. The home as well as the land around it serve as collateral for the lender.
What makes up a mortgage payment?
There are four factors that are involved in the calculation of a mortgage payment. They are principal, interest, taxes and insurance. When reviewing these, we’ll use the example of a $100,000.00 mortgage.
A portion of your monthly mortgage payment is applied to the repayment of the principal of the home loan. Home loans are structured so that pay down on the mortgage principal starts small and increases with every monthly mortgage payment made. The early years of your mortgage payments consists primarily of interest payments, and the later years of your monthly mortgage payments consists primarily of principal reduction. On a $100,000.00 home loan, the principal is $100,000.00.
Interest on a home loan is what the lender makes for taking the risk in loaning you the money for your mortgage. The interest rate you are given has a direct impact on the amount of your monthly mortgage payment – higher interest rates mean higher monthly payments. On a $100,000.00 mortgage, if the interest rate is 6%, the combined principal and interest payment would be around $599.00 ($500 to interest and $99.00 to principal). The same loan at a 9% interest rate results in a monthly mortgage payment of around $804.00.
Real Estate taxes are used to fund various local public services like schools, road construction, police and fire department services. The government calculates these taxes on a per-year basis, and these taxes can be a part of your monthly mortgage payment of you wish. If you roll your taxes in to your mortgage, the lender collects the payments and holds them in an account called an Escrow Account, until the taxes are due to be paid.
There are two types of insurance that may be included in a mortgage payment. Just like taxes, insurance payments are made with each monthly mortgage payment and held in escrow until the bill is due. The two types of insurance are property insurance, which protects the home and contents from fire, theft and other unforeseen disasters, and Private Mortgage Insurance (PMI), which is mandatory if you put less than a 20% down payment. PMI protects the lender in the case that the borrower defaults on their loan. PMI insurance can be dropped once the borrower has at least 20% equity in their home.
A home mortgage is a critical tool for buying a house. When getting a home mortgage, it’s important to understand the structure of your payments, which include the components of principal, interest, taxes and insurance. The structure of your loan determines how long it will take to repay your mortgage debt and how expensive it will ultimately be to finance your home over the term of your mortgage.