Your mortgage payment might seem to be straightforward, but many people mistakenly think that their loan amount will go down by the amount of the payment. In fact, it is a little more complicated than that.
There are four components to a mortgage payment, and understanding how much of your payment goes to each can help you better understand when you will be able to pay it off.
Principal is a fancy term for the actual amount of the loan. Each loan payment will contain some amount of principal. One thing that is commonly misunderstood is that the percentage of the payment that goes to the principal increases over time.
Therefore, you can't simply divide your principal by the number of payments and know how much you have paid off. And, of course, in the early stages of the loan, you won't be paying much principal at all. However, you can talk to your lender about adding a bit extra to each payment or an extra payment a year that can be applied to the principal. Make sure they do apply it to the principal. One easy way is to round up your regular payment to the next hundred dollar amount. This might not seem like much, but it helps.
The next major component is interest. At the start of the loan you will pay more interest, proportionately, but it will eventually taper off. The amount of interest you pay depends on the terms of your loan. Shorter loans generally have higher interest rates. Other things which affect your interest rate include the loan amount and your credit score. You should try to improve your credit score as much as possible before taking out the loan.
Negotiating your loan to get a better interest rate includes taking into account how long you plan on staying in the home. Make sure to do the math to work out what you will end up paying in interest over the life of the loan.
Property taxes are levied by jurisdictions and generally used to find local public services. Your lender may collect your property taxes as part of the payment and then hold them in escrow until the end of the year. This has a couple of advantages: you aren't hit by a huge bill at the end of the year and if the tax amount isn't as expected, your lender will generally cover the difference then bill you for it in future payments. It also allows you to avoid the potential of a property tax lien, which benefits both you and your lender.
Lenders generally require escrow if you can't manage a 20% down payment, as it also protects them from a large property tax bill if they have to foreclose. FHA loans also require escrow accounts.
There are two types of insurance that might be added to your payments.
First, in order to make sure the home is appropriately insured, some lenders will also collect homeowners insurance payments and pay them out of the escrow. If necessary, they may also collect flood insurance. Lenders will often give you more favorable terms if you agree to this. Lenders cannot require you to use a specific insurer or insure for an amount over appraised value, but they absolutely can require you to have homeowners insurance and flood insurance.
The second is private mortgage insurance (PMI). PMI is required if your down payment is less than 20% and must be maintained until a certain amount of the loan has been paid off. PMI protects only the lender, not you, but you pay for it. Saving up a 20% down payment is the best way to avoid having to pay for PMI.
So, there you have it; the four components of your mortgage payment. When working out your loan, you need to keep all of these in mind to make sure that your total payment stays within your budget. If you need help with this, contact one of our expert local loan officers. We can help you understand your mortgage payments and work out the best way to keep them low.