You know you’ll make a mortgage payment every month when you buy a house, but do you know what goes into that mortgage payment? It’s more than just principal and interest, although that’s a big part of it. You should know what you are paying and why when you take out a mortgage.
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The Principal
The principal is the amount you borrowed amortized over the term of the loan. For example, if you borrowed $200,000 for 30 years, your principal is the $200,000 spread out over those 30 years. Just how it is spread out depends on several factors including the chosen term and interest rate.
The principal is what you’ll want any extra payments that you make to go towards. You should always mark you check or put a note on an electronic payment to make sure the money goes to the principal. The fast your pay your principal down, the less interest you’ll owe on the loan. You may even own your home faster if you pay the principal down fast enough.
The Interest
The interest is the fee you pay for borrowing the money. Each borrower and each loan has a different interest rate. Lenders tend to save the best interest rates for borrowers with great credit, low debt ratios, and a low overall risk of default. As your risk of default increases, due to bad credit or a high debt ratio, the lender starts to increase the interest rate charged.
You’ll see the breakdown of the interest you’ll pay on your mortgage payments on the amortization schedule. This is if you pay the minimum payments each month. If you make extra principal payments, you’ll owe less interest over the life of the loan.
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Mortgage Insurance
If you borrow money with an FHA or USDA loan, you’ll pay mortgage insurance for the life of the loan. If you use conventional financing, but put down less than 20%, you’ll pay Private Mortgage Insurance until you owe less than 80% of the home’s value.
Mortgage insurance can add several hundred dollars to your principal and interest. Make sure you know exactly how much the mortgage insurance will cost you. In the case of the FHA or USDA loans, you can’t request cancelation of the insurance. If you have a conventional loan, you can request elimination of the insurance once you owe less than 80% of the home’s value. But that could take you a while depending on how much you borrowed, so you should pay close attention to its cost.
Real Estate Taxes and Homeowner’s Insurance
Most loans include an escrow account, which holds the money to pay your real estate taxes and homeowners insurance. You pay a set amount each month towards your escrow account, but the amount can change yearly.
Your lender will determine the cost of your real estate taxes and homeowner’s insurance, add a small cushion to it, and divide that amount by 12 months. You then make an escrow payment towards your escrow account every month. Once a year, your lender will conduct an escrow analysis to make sure you are not paying too much or too little towards your escrow account. If you have a surplus in your escrow account, they will refund your money. If you have a shortage, you’ll have a higher monthly payment towards your escrow for the next year to make up for it.
There are many moving parts to your mortgage payment. Make sure you know exactly what you are paying and what is necessary. If you have options, ask your lender about the various options and how they will work out over the life of the loan.