Understanding the Mortgage Payment Structure

A mortgage is a long-term loan designed to help you buy a house. In addition to repaying the principal, you also have to make interest payments to the lender. The home and the land around it serve as collateral. However, if you are looking to own a home, you need to know more than these generalities.

History

Just 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 culture.

The modern mortgage came into being in 1934, when the government, to help the country overcome the Great Depression, created a mortgage program that minimized the required down payment on a home, increasing the amount that potential homeowners could borrow. Before that, a 50% down payment was required. Today a 20% down payment is desirable, mostly because if your down payment is less than 20%, you are required to take out private mortgage insurance (PMI), making your monthly payments higher.

Desirable, however, is not necessarily achievable. Indeed, Nerdwallet reported in 2017 that the National Association of Realtors said that “more than 70% of non-cash, first-time home buyers – and 54% of all buyers – made down payments of less than 20% over at least the past five years.” There are indeed mortgage programs available that allow significantly lower down payments, but if you can manage that 20%, you definitely should.

Mortgage Payments

The main factors determining your monthly mortgage payments are the size and term of the loan. Size is the amount of money you borrow and term is the length of time you have to pay it back. Generally, the longer your term, the lower your monthly payment. That’s why 30-year mortgages are the most popular. Once you know the size of the loan you need for your new home, an easy way to compare mortgage types and various lenders is by using a mortgage calculator

PITI: The Components of a Mortgage Payment

There are four factors that play a role in the calculation of a mortgage payment: principal, interest, taxes and insurance (PITI). As we look at them, we’ll use a $100,000 mortgage as an example.

Principal

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 low and increases with each mortgage payment. The payments in the first years are applied more to interest than principal, while the payments in the final years reverse that scenario. For our $100,000 mortgage, the principal is $100,000.

Interest

Interest is the lender’s reward for taking a risk and loaning you money. 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 more, see: Mortgages: Fixed-Rate Versus Adjustable-Rate.) Higher interest rates generally reduce the amount of money you 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.)

Taxes

Real estate taxes are assessed by governmental agencies and used to fund public services, such as schools, police forces and fire departments. Taxes are calculated by the government on a per-year basis, but you can pay these taxes as part of your monthly payments. The amount due 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 have to be paid.

Insurance

Like real-estate taxes, insurance payments are made with each mortgage payment and held in escrow until the bill is due. There are two types of insurance coverage that may be included in a mortgage payment. One is property insurance, which protects the home and its contents from fire, theft and other disasters. The other is PMI (mentioned above), which is mandatory for people who buy a home with a down payment of less than 20% of the 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 home.

While principal, interest, taxes and insurance make up the typical mortgage, some people opt for mortgages that do not include taxes or insurance as part of the monthly payment. With this type of loan you have a lower monthly payment, but you must pay the taxes and insurance on your own.

How Mortgages Work: the Amortization Schedule

A mortgage’s amortization schedule provides a detailed look at 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; later payments consist primarily of principal.

In our example of a $100,000, 30-year mortgage, the amortization schedule has 360 payments. The partial schedule shown below demonstrates how the balance between principal and interest payments reverses over time, moving toward greater application to the principal.

Payment Principal Interest Principal Balance
1 $99.55 $500.00 $99,900.45
12 $105.16 $494.39 $98,772.00
180 $243.09 $356.46 $71,048.96
360 $597.00 $2.99 $0

As the chart shows, each payment is $599.55, but the amount dedicated toward principal and interest changes. At the start of your mortgage the rate at which you gain equity in your home is much slower. This is why it can be good to make extra principal payments (if the mortgage permits you to do so without a prepayment penalty). They reduce your principal, which in turn reduces the interest due on each future payment, moving you toward your ultimate goal: paying off the mortgage.

On the other hand, the interest is the part that's tax-deductible to the extent permitted by law – if you itemize your deductions instead of taking the standard deduction.

When Do Mortgage Payments Usually Start?

The first mortgage payment is due one full month after the last day of the month in which the home purchase closed. Unlike rent, due on the first day of the month for that month, mortgage payments are paid in arrears, on the first day of the month but for the previous month. Say a closing occurs on Jan. 25. The closing costs will include the accrued interest until the end of January. The first full mortgage payment, which is for the month of February, is then due March 1.

As an example, let’s assume you take an initial mortgage of $240,000, on a $300,000 purchase with a 20% down payment. Your monthly payment works out to $1,077.71 under a 30-year fixed-rate mortgage with a 3.5% interest rate. (This calculation only includes principal and interest; it does not include real estate taxes and insurance.)

Your daily interest is $23.01. This is calculated by first multiplying the $240,000 loan by the 3.5% interest rate, then dividing by 365. If the mortgage closes on Jan. 25, you owe $161.10 for the seven days of accrued interest for the remainder of the month. The next monthly payment, which is the full monthly payment of $1,077.71, is due on March 1 and covers the February mortgage payment.

You should have all this information in advance. Under the TILA-RESPA Integrated Disclosure rule, two forms must be provided to you three days before the scheduled closing date – the loan estimate and closing disclosure. The amount of accrued interest, along with other closing costs, is laid out in the closing disclosure form. You can see the loan amount, interest rate, monthly payments and other costs, and compare these to the initial estimate that was provided. However, in January 2018 the Chicago Tribune reported that the Trump administration, inclined to deregulation, is considering proposing a change to this rule, so keep your eyes peeled.

The Bottom Line

A mortgage is an important tool for buying a house, allowing you to become a homeowner without making a large down payment. However, when you take on a mortgage, it’s important to understand the structure of your payments, which cover not only the principal (the amount you borrowed) but also interest, taxes and insurance. It tells you how long it will take you to pay off your mortgage and, ultimately, how expensive it will be to finance your home purchase.