Here’s a little known fact: Before mortgages were created by the federal government, it was typical for a down payment for a home to be 50% or more, after which the remainder had to be paid in full. Thankfully, we now have access to loans and much lower down payments. Almost all homeowners buy a property through a mortgage now.
Yet surprisingly, many don’t know how their actual payments work. You know how much you have to pay and by what date—but do you actually know how it’s all broken down and figured out? if not, you should.
In Simplest Terms…
What you’ll be borrowing—and what you’ll be paying back each month—is determined by the size (amount of money) and term (length of time) of your mortgage. Longer terms mean smaller payments, so it’s not surprising that a 30-year mortgage is more popular than a 15-year mortgage.
The PITI Factor
Delving a little deeper, there are four items that determine your monthly payments: principal, interest, taxes, and insurance. The principal is the amount of money you actually borrowed to buy your home, and the amount of principal that’s paid within each monthly payment increases over time; as you continue paying, the amount of principal gets higher and the interest amount gets lower.
Think of interest as your involuntary thank you to the bank. It’s what they get for lending you the money, and of course higher interest rates mean higher payments, or the ability to borrow less.
Taxes are collected by the lender with your mortgage payment, held in escrow, and then paid to the government. They go toward public schools, police and fire service, community improvements, and various necessities.
Finally, insurance protects you and your home, and like taxes, is collected by the lender and then paid on your behalf.
Here’s where it gets tricky: you are not paying the same amount of each of these four factors every month throughout the entire time you own your home. The balance between principal and interest payments changes and eventually reverses over time, and the amortization schedule shows what part of your payment is going to which. You can keep track of the schedule to know how much principal is being paid off along the way.
At the end of the day, you’ll be paying the same amount each month, but it’s always wise to know exactly what you’re paying and why. Being an informed borrower is always a good decision.