How mortgages work: Understanding the key elements
A mortgage is a long-term loan that a borrower obtains
from a bank, thrift, independent mortgage broker, online lender or even the
property seller.
The house and the land it sits on serve as
collateral for the loan. The borrower signs documents at closing time giving the
lender a lien against the property. If that borrower doesn't make payments as
agreed, the lender can take the home through foreclosure.
Because mortgages are such large loans, consumers pay them off
over long periods -- usually 15 to 30 years. Their monthly payments gradually
whittle away the principal balance, slowly at first then rapidly toward the end
of the loan.
What's in a payment?
When escrow is used, a monthly mortgage payment is called a PITI payment. That's
because each one covers a portion of the following four costs:
Principal -- the loan
balance
Interest -- interest owed on that balance
Real estate Taxes -- taxes assessed by different government agencies to
pay for school construction, fire department service, etc.
Property Insurance -- insurance coverage against theft, fire,
hurricanes and other disasters
Borrowers can choose to pay their real estate
taxes and insurance in lump sums when they come due, rather than in monthly
installments to their escrow accounts.
Depending on the kind of mortgage a borrower
has, the monthly payment may also include a separate levy for private mortgage
insurance (PMI) or government-backed mortgage insurance premiums.
The breakdown of each payment (the amount
that goes toward principal, interest, etc.) changes over time because mortgages
are based on a repayment formula called amortization. That's a fancy term
meaning the lender spreads the interest you owe on the mortgage over hundreds of
payments so that the overall loan is as affordable as possible.
How does amortization work?
|
|
Payment number
|
Principal balance
|
Payment amount
|
Interest paid
|
Principal applied
|
New balance
|
|
1
|
$150,000
|
$1,048.82
|
$937.50
|
$111.32
|
$149,888.68
|
|
60
|
$142,086.93
|
$1,048.82
|
$888.04
|
$160.78
|
$141,926.15
|
|
120
|
$130,426.14
|
$1,048.82
|
$815.16
|
$233.66
|
$130,192.48
|
|
240
|
$88,851.22
|
$1,048.82
|
$555.32
|
$493.50
|
$88,357.72
|
|
359
|
$2,078.14
|
$1,048.82
|
$12.99
|
$1,035.83
|
$1,042.3
|
|
|
On a 30-year, $150,000 mortgage with a fixed
interest rate of 7.5 percent, a homeowner who keeps the loan for the full term
will pay $227,575.83 in interest.
The lender can't possibly expect that person
to pay all that interest in just a couple of years so the interest is spread
over the full 30-year term. That keeps the monthly payment at $1,048.82.
But the only way to keep the payments stable
is to have the majority of each month's payment go toward interest during the
early years of the loan.
Of the first month's payment, for instance,
only $111.32 goes toward principal. The other $937.50 goes toward interest. That
ratio gradually improves over time, and by the second-to-last payment, when
we're all driving hovercars and have colonized the moon, $1,035.83 of the
borrower's payment will apply to principal while just $12.99 will go toward
interest.
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