March 14th, 2017 7:16 AM by Jackie A. Graves, President
simplest terms, a mortgage is
a long-term loan designed to help the borrower purchase a house. In addition to
repaying the principal, the borrower is obligated to make interest payments
to the lender, and the home and the land around it
serve as collateral. But if you are looking to purchase
a house, you need to know more than these generalities. In this article, we'll
look at how a mortgage functions and how it is paid off.
about everyone who buys a house has a mortgage. Mortgage rates are frequently mentioned on the
evening news, and speculation about
which direction the rates will move has become a standard part of our financial
may seem like mortgages have always been available, the modern mortgage came
into being only in 1934, when the government, to help the country overcome the Great Depression,
created a mortgage program that minimized the required down payment, thereby increasing the amount
that potential homeowners could borrow. Before the creation of this mortgage
program, a 50% down payment was required to purchase a home. Today, a 20% down
payment is desirable (as it minimizes private mortgage insurance (PMI) requirements), but there are
mortgage programs available that allow significantly lower down payments. (For
more on PMI, see Understanding
primary factors determining your monthly mortgage payments are the size and
term of the loan. 'Size' refers to the amount of money borrowed and 'term'
refers to the length of time within which the loan must be fully paid back.
There is an inverse relationship between the term of the loan and the size of
the monthly payment: longer terms result in smaller monthly payments. For this
reason, 30-year mortgages are the most popular mortgage type. If you are
shopping for a mortgage, once you know the size of the loan you require for
your new home, an easy way to compare mortgages types and various lenders is by
using a mortgage calculator.
size and term of the loan have been determined, there are four factors that
play a role in the calculation of a mortgage payment. Those four items are
principal, interest, taxes and insurance (PITI). As we look at these four factors, we'll
consider a $100,000 mortgage as an example.
A portion of each mortgage payment is dedicated to repayment of
the principal. Loans are structured so that the amount of principal returned
to the borrower starts out small and increases with each mortgage payment.
While the mortgage payments in the first years consist primarily of interest
payments, the payments in the final years consist primarily of principal
repayment. For our $100,000 mortgage, the principal is $100,000.
Interest is the lender's reward for taking a risk and loaning money to a borrower.
The interest rate on a mortgage has a direct impact on the size of a mortgage
payment - higher interest rates mean higher mortgage payments. (For further
reading on different types of mortgage interest rates, see: Mortgages: Fixed-Rate Versus Adjustable-Rate.)
So, for most home buyers, higher interest rates reduce the amount of money
they can borrow, and lower interest rates increase it. If the interest rate
on our $100,000 mortgage is 6%, the combined principal and interest monthly
payment on a 30-year mortgage would be something like $599.55 ($500 interest
+ $99.55 principal). The same loan with a 9% interest rate results in a
monthly payment of $804.62. (To get an idea of what monthly payment results
from a particular principal and interest rate, see this calculator.)
Real estate taxes are assessed by governmental
agencies and used to fund various public services such as school construction
and police- and fire-department services. Taxes are calculated by the
government on a per-year basis, but individuals can pay these taxes as part
of their monthly payments. The
amount that is due in taxes is divided by the total number of monthly
mortgage payments in a given year. The
lender collects the payments and holds them in escrow until
the taxes are due to be paid.
There are two types of insurance coverage which may be included in a mortgage
payment. Like real-estate taxes, insurance payments are made with each
mortgage payment and held in escrow until
the bill is due. The first type of insurance is property insurance,
which protects the home and its contents from fire, theft and other
The second type of insurance is PMI (mentioned above), which is mandatory for
homeowners who purchase a home with a down payment of less than 20% of the
home\'s cost. This type of insurance protects the lender in the event the
borrower is unable to repay the loan. Because it minimizes the default risk on the loan, PMI also enables
lenders to sell the loan to investors, who in turn can have some assurance
that their debt investment will be paid back to them. PMI
coverage can be dropped once the borrower has at least 20% equity in the
principal, interest, taxes and insurance comprise a typical mortgage, some
borrowers opt for mortgages that do not include taxes or insurance as part of
the monthly payment. With this type of loan, borrowers have a lower monthly
payment but must pay the taxes and insurance on their own.
mortgage's amortization schedule
provides a detailed look at precisely what portion of each mortgage payment is
dedicated to each component of PITI. As noted earlier, in the first years
mortgage payments consist primarily of interest payments, as it gradually moves
toward the principal becoming greater.
example of a $100,000, 30-year mortgage, the amortization schedule consists of 360 payments. The partial
amortization schedule shown below demonstrates how the balance between
principal and interest payments reverses over time as later payments consist
primarily of principal.
the chart shows, each of the required payments is $599.55, but the amount
dedicated toward principal and interest varies from payment to payment. Because
of the inverse relationship between principal and interest paid, at the start
of your mortgage the rate at which you gain equity in
your home is much slower. This demonstrates the value of making extra principal
payments if the mortgage permits pre-payment. Each extra payment results in a
larger repaid portion of the principal, and reduces the interest due on
each future payment, moving the homeowner toward the ultimate goal: paying off
mortgage is an important tool for buying a house, as it allows individuals
become homeowners without making a large proportional down payment. However,
when you take on a mortgage, it's important to understand the structure of your
payments, whose components are dedicated not only to the principal (the amount
you borrowed) but also interest, taxes, and insurance. This structure
determines how long it will take to pay off the mortgage and, in turn, how
expensive it will ultimately be to finance your home.
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