After the ink is dry and you have closed on your brand new home, you may think the complex part is over. This is mostly true. Most of the heavy lifting - apart from physically moving in - is done during the home buying process.
Paying down the mortgage loan, what you will be doing for somewhere between 20 to 30 years, is not over complicated, though it does involve more than paying one mysterious sum once a month.
Mortgage payments can be broken down into 4 parts. Knowing how each part works is important for every home buyer, especially as you are committing to such a long term and substantial loan. It’s vital to understand what you are paying for, so be sure to dig into this stuff after the initial celebrations for buying a house are over.
Principal
The principal is the amount of money you owe the bank, or the loan amount still outstanding. It’s the amount you think of when the term mortgage payment pops up. This amount will not change in the lifetime of your mortgage, as it is the balance taken out to pay for your home, and has to be repaid as that amount. Not much has to be known about the principal, other than it has to be paid back month to month. It’s the other three components that are often overlooked or misunderstood.
Interest
This part of the payment is the cost of borrowing money. Before you close on your home, you secure a favorable interest rate with your lender, as they are the ones charging you for their services. It’s important to note that the higher the interest rate you get for your loan, the higher the monthly payment will be. So when you are figuring out your budget for this enormous purchase, don’t forget to factor in the interest rate.
Taxes
When you’re deep into the home buying process, it’s easy to forget that you will have to pay property taxes on your home, as part of of the monthly loan costs. The amount is based on how your local government assesses your property, and is often built into your monthly payment by the lender. It’s how much you owe yearly, divided into 12 installments attached to your mortgage payments. The money you pay the lender goes into an account held in escrow, and that amount is paid at the end of the year when the tax bill arrives. As property tax rates tend to change over time, the amount you pay for this portion of the mortgage loan will also vary.
Insurance
It’s also easy to overlook having to pay for insurance when you are buying a home. Collected by the lender, this is the fourth and maybe most vital part of the monthly mortgage loan payment, as it’s what protects both you and the lender from risk. Homeowners insurance is collected to protect against potential hazards that could damage your home, and mortgage insurance (PMI) protects the lender. PMI is paid when the buyer hasn’t put down 20% on the initial payment, meaning the lender is requiring payment for risk. Once the buyer has 20% of their home, they can drop this. Like the money spent on taxes, insurance payments is held in an escrow account and eventually paid to the insurance company.
What’s super interesting in this payment process is that in the lifetime of your mortgage loan, the principal will eventually go from relatively low to high, while the interest will start big, and gradually be reduced. This is because the amount owed gets lower and lower. Remember that in a fixed rate loan, the total payment amount won’t change; the balance of what you are paying under that umbrella of the loan will. When you start thinking about an adjustable rate mortgage, this will change, and become less predictable. Talk to your lenders about both options, to see which is right for you, and never hesitate to ask for the breakdown of costs, so you consistently know what you’re paying for.
