A mortgage is a great way to purchase a home without paying the entire amount upfront. With a mortgage comes a monthly payment to the lender. This mortgage payment has four components, principal, interest, taxes, and insurance (PITI).
What Is Your Principal Payment?
The main component of the loan is the principal. This is the amount loaned to you by the mortgage loan officer. If you purchased a $300,000 home, $300,000 is the principal. If you make a 20% down payment, essentially $60,000, then your principal is $240,000.
Kris Farwell, Director of Mortgage at Coulee Bank, says, “The mortgage principal is not the entire sum of money you owe on the home. A portion of your monthly payment goes towards the outstanding principal and the interest rate.”
In the early stages of the loan, a larger portion of your monthly payment is allocated to interest. This is because the principal—the initial amount borrowed—is at its highest. Interest is calculated as a percentage of the remaining principal, so when the principal is high, the interest portion of your payment is also significant. Farwell says, “As the loan matures, more of your monthly payment is applied to the principal. This is known as amortization. Amortization allows the borrower to have predictable monthly payments and build equity over time.”
What Is Interest?
Interest is the fee you pay the bank for lending you the money. Interest rates are largely influenced by the Federal Reserve (the Fed), but your credit rating, income, down payment, and the location of the home can also influence the interest rate. Higher interest rates cause the monthly payment to increase and therefore decrease how much money you can borrow. “Don’t let that discourage you from purchasing a home. Buy the house and rent the rate,” says Farwell.
Farwell notes that in 1971 the average interest rate was just over 7% (vs. approx. 7% currently). At that time, if you’d waited to buy until the interest rates went down, you would have waited until 1993. That means whatever home or apartment you lived in during those years would have helped your landlord gain equity in the property they owned. Meanwhile, real estate values quadrupled in the same 22-year period.
What Taxes Are Included in My Monthly Mortgage Payment?
Most of the time, your monthly mortgage payment includes property taxes imposed by local governments to fund libraries, parks, police and fire, and other services. Including taxes in your monthly mortgage payment helps you avoid paying thousands of dollars in one lump sum. Farwell says, “If the taxes are wrapped into your mortgage payment, the lender collects the payment and holds it in escrow until the taxes must be paid. An escrow is a financial agreement where a third party, usually the lender, holds the funds until the bill is due. When the bill comes due, the lender pays it.”
The amount due for property taxes (and possibly insurance) is divided by the total number of monthly mortgage payments you will make in a year. This typically results in 12 monthly contributions.
What Types of Insurance Are Included in a Mortgage Payment?
Like your property taxes, insurance payments are made with each mortgage payment and held in escrow until the bill is due. Once again, the third party, usually the lender, holds the money and pays the bill when it comes due. Farwell says, “Insurance can be broken down into two components. You may have private mortgage insurance if your down payment is less than 20%. This protects the lender if you default on your mortgage.” She says homeowner’s insurance protects your home and its belongings from damage caused by fire, theft, weather, vandalism, and other unexpected events.
When considering purchasing a home, evaluate various components that impact your monthly payment costs. It's not just about the principal amount you're borrowing. Several factors play a significant role in determining how much house you can afford. Contact Coulee Bank and talk to a mortgage professional today.