Components of a Mortgage
A mortgage is nothing more than a long term loan, the primary components of which are the principle, interest, and term. In addition, property tax and insurance payments are normally added to your monthly payments. This combination of principle, interest, taxes, and insurance are often refereed to as PITI, and they determine your monthly payment. You'll learn about each of these components below, along with the pros and cons of different loan configurations.
The principle is the amount of money you borrow, or the loan amount. Part of each monthly payment will go toward paying down your principle. But, loans are structured so payments at the beginning of the term primarily go toward interest, and payments at the end of the term primarily go toward principle. Therefore, in the first years of a typical 30 year mortgage you pay off a very small amount of the principle.
Interest is what you pay to the lender in order to get your loan. It's how the lender makes money. Your interest rate is extremely important, as it will have a dramatic affect on both your monthly payment and your interest payments in total. Here's an example of the affects of various interest rates on a 30 year mortgage for $200,000:
Interest Rate: 6%
Monthly Payment: $1,199.19
Total Mortgage Payments: $431,676
Interest Rate: 8%
Monthly Payment: $1,467.53
Total Mortgage Payment: $528,310
An interest rate difference of just 2% (from 6% to 8%) on a $200,000, 30 year mortgage will increase your monthly payment by $268.34, and your total mortgage payments by $96,634! Your goal should be to have the lowest interest rate possible. Try our free mortgage calculator to see the affect different interest rates will have on your mortgage payments.
There are two primary types of interest rates for mortgages, fixed and adjustable rate. Fixed rate mortgages have the same rate throughout the length of the loan, whereas adjustable rate mortgages (ARMs) have variable rates. For more information on fixed vs. adjustable rates, see our article on fixed mortgages vs. ARMs. You can also compare the difference between fixed and adjustable rate mortgages with our ARM vs Fixed Rate Mortgage Calculator.
The term is the amount of time you'll have your mortgage. The average mortgage term is 30 years, but you can also get a 10, 15, 20, 25...even a 50 year mortgage! There are two things that are important to remember about the term:
- Shorter terms mean higher monthly payments and longer terms mean lower monthly payments.
- Shorter terms mean you pay less interest over time, and longer terms mean you pay more interest over time.
So while a shorter term means you'll pay a larger monthly payment, you'll save money in the long run since you'll pay less interest and pay off your loan faster. Let's take a look at an example from our Mortgage Term Comparison Calculator, again for a $200,000 mortgage with a 6% fixed interested rate:
Term: 10 years
Monthly Payment: $2,220
Total Payments: $266,449
Term: 20 years
Monthly Payment: $1,433
Total Payments: $343,887
Term: 30 years
Monthly Payment: $1,199
Total Payments: $431,676
As you can see, the monthly payment for a 10 year mortgage is much higher than for a 30 year, but you save $165,227 by paying your mortgage off 20 years earlier! One thing to keep in mind however is that if you have a low fixed interest rate (lower than what you could make by investing your money minus inflation) you're probably better off investing the difference from the lower monthly payment even though you'll be paying more mortgage interest in the long term.
Insurance & Taxes
Insurance and tax payments are added to your monthly mortgage payments. Banks require this to keep their investment safe, as if something would happen to your home (which is their collateral on your loan), it will be insured. There are two types of insurance you may have to pay: basic home owner's insurance and private mortgage insurance or PMI.
Your basic home owner's insurance will cover your home and its contents in case of disaster. You should check to see exactly what kind of disasters this covers, as you may need to purchase separate "flood insurance" for example. PMI is required for anyone making less than a 20% downpayment. This insurance is a protection for your lender, in case you default on your loan. Your PMI can be dropped once you've paid enough principle to get over 20%.
In addition to insurance, your real estate taxes will also be added to your monthly payments. The way it works is your estimated tax bill is divided by the number of payments you'll make in a year, and your lender will hold those payments in order to cover your tax payment at year end. Our free Mortgage Calculator will allow you to add both types of insurance and taxes in order to calculate your real monthly payment.
Your mortgage's amortization schedule will show you exactly what portion of each payment is going to interest and principle, which will change over the life of your mortgage. Our Mortgage Calculator will allow you to create a printable report showing your amortization schedule for your reference.