Your Mortgage Payment Explained: Principal, Escrow, and More
A mortgage payment is a significant amount of budget spent each month. Contrary to what you may have thought, it’s more than just a house payment. There are taxes, fees, and other line items that may not be easily understood until undertaking a mortgage.
They are relatively easy to see, though. Take a look at your mortgage statement. Do you see a breakout of charges? These charges typically fall into the following categories:
Principal. The money owed to pay your loan balance. This is specifically based on the amount of money borrowed and does not include interest.
Interest. A percentage charged to the loan balance as repayment to the lender.
Escrow. Escrow is money set aside so a third party can pay property taxes and homeowners’ insurance premiums on your behalf. Why? Each month, homeowners are required to pay a portion of their estimated annual costs, including principal and interest. Current law permits a lender to collect 1/6th (two months) of the estimated annual real estate taxes and insurance payments at closing. After closing, you will remit 1/12 of the annual amount with each monthly mortgage payment. So, your statement will include a line item -- “escrow” which states just how much you owe for that month.
Looking under escrow you will see:
Taxes. Here we are talking about property taxes, which are owed by you - the homeowner. Each monthly mortgage payment will include 1/12 of your annual property tax bill. Those monies are often kept in an escrow account, which is further defined below.
Insurance. If you see the general term “insurance” on your statement, it’s referring to hazard or homeowners’ insurance. You’ll make an initial year’s worth of payments before closing, as part of your closing costs. This insurance will cover you against losses related to your home structure, like fire or hail damage. Going forward, and similar to taxes, your lender will collect 1/12 payment to cover ongoing premiums.
Mortgage Insurance. As far as mortgage insurance goes -- that’s dependent on the loan program and the amount of down payment you made. If you put less than 20% down or are using an FHA loan, expect mortgage insurance fees to also live on your statement. It’s purpose: to protect the lender against losing its investment.
Keep in mind your lender should receive copies of your tax and insurance bills so they can pay them out of the escrow funds collected. You should not be making payments directly to a tax or insurance agent -- specific to property taxes, homeowners’ insurance, and mortgage insurance.
Key takeaway: Escrow helps borrowers by evenly spreading insurance and tax expenses over 12 payments instead of one lump sum. Let’s assume your yearly property taxes are two payments of $1,000 each, and your annual insurance is $600. If you paid these directly, it would mean $2,600 a year. With escrow, though, you can expect to make smaller, monthly payments of $217.
Now that you’ve been reminded of what’s on your bill, let’s breakdown different stages within your mortgage repayment schedule.
Start of loan: understanding arrear payments
Unlike most loans, mortgage principal and interest are paid in arrears -- or paid after interest is accrued. So, when buying a home, your first payment is due at the beginning of the first full month after closing. If you close on April 10, your first payment is not due until June.
However, when you close on your mortgage loan, the lender will collect interest on all remaining days of the month you close. If you close on the 15th of a 30-day month, there will be 16 days of interest collected – the number of days remaining in the month, including the 15th. This ensures all payments are the same amount. The closer you are to an end of month closing, the less interest you owe that month (since interest is prorated by day).
Key takeaway: As you likely expected, you eventually pay all of the interest due--neither more nor less. If you’re in need of lower closing costs, you can discuss seller concessions with your realtor or assistance programs with your mortgage lender.
Duration of loan: how your loan amortizes
Amortization is how your mortgage lender calculates your monthly payments. Since you are being charged interest over the duration of your loan, your monthly mortgage payment has to be divided among the principal balance and interest. To do this, the lender looks at the original loan balance after your last payment and calculates the amount of monthly interest owed vs. the amount applied toward principal.
Let’s consider an example of a $200,000, 30-year conventional mortgage at 4% interest (for illustrative purposes only). You’ll notice the sum of the principal and interest payments always equals $955, but disbursement of dollars varies based on how far along you are with repayment.
After a year of mortgage payments, 31% of your money starts to go toward principal. You see 45% going toward principal after 10 years and 67% going toward principal after year 20.
Over 30 years you'll pay a total of $343,739, again based on an estimated monthly mortgage payment of $955.
Key takeaway: the more you pay toward principal, the greater amount of equity you gain. Equity is an extremely important asset that is often taken advantage of via a home loan refinance. In this example, equity grows at a slower pace. But keep in mind -- there are many loan programs that amortize differently. That’s why it’s extremely important to discuss your financial goals with your loan officer during the mortgage process.
End of loan: payoff vs. principal balance
As you approach the end of your loan term, inching closer to being mortgage free, it becomes time to settle your balance. Your outstanding principal -- as shown on your mortgage statement -- is not the total amount needed to pay off your loan. This is because interest will accumulate up until the day your loan closes. And, there may be other fees you’ve incurred but not yet paid, such as late fees, deferred interest, hazard/flood insurance, etc. Bottom line - expect a balance that’s higher than your principal balance. This is what’s called a payoff amount or payoff quote.
Key takeaway: The easiest way to determine your payoff balance -- call your mortgage servicer. It’s far easier and more accurate than doing the math yourself. You can request a payoff quote that will illustrate exactly what needs paying before the loan is resolved. Just know that payoff quotes have expiration dates, and some servicing companies may even include a charge to have your payoff faxed or emailed to you. If you do not pay your account in full before the quote expiration date, your payoff amount will change.
Home ownership is exciting, especially as you get closer to owning a house that’s free from a mortgage. But the overall term is lengthy -- no shorter than 15 years, and often closer to 30 immediately after a home purchase. A lot can happen during that timeframe. If questions arise during the loan repayment or payoff process, never hesitate to speak with your Mortgage Consultant. It’s important for you to understand mortgage payment structure, as well as refinance options that may lower monthly payments as interest rates become more competitive.