The Building Blocks of Mortgages

At that time, mortgages were built out of interest rate components and full repayment by the end of the 30 years because the FHA did not allow pre-payment penalties.

Today a mortgage has many parts, and they're often not as simple as they seem. Examine each part of a mortgage to understand the cost of homeownership.

The Principal

The principal is the actual loan itself, the amount you borrow and must pay back to the bank or lender. It's also known as the loan's face value, and it's calculated by adding up all the payments that you'll make. For example, if you had a 30-year fixed-rate mortgage with a $250,000 principal and your monthly payment was $1,500—$750 for principal and interest each month—your total principal would be $258,500.

The Interest

The interest is the amount you pay for borrowing money from your lender and is typically expressed as an annual rate. This compound interest adds up over time. For example, if you borrowed $250k at a 4 percent rate and made your monthly payments for 30 years to pay off your loan—that would be approximately $2,013 per month in interest alone! Over time it can become quite substantial.

Equity

The mortgage industry uses "equity" to mean the difference between what you owe on your home and its market value. Equity is expressed as a percentage of the home's value. For example, if your home is worth $200,000 and you owe $150,000 on your loan, you have $50,000 in equity. From a lender's perspective, equity is vital because it provides a cushion if your income disappears or you go bankrupt.

Taxes and Insurance

The borrower pays taxes and insurance to the lender to ensure that all loan payments are made and that the lender receives its money if there is a default. If the borrower defaults on the loan, then the lender will use those payments to pay off the loan balance. This includes all property taxes, hazard insurance premiums, and private mortgage insurance if the lender requires one.

Mortgage Insurance

Private mortgage insurance (PMI) protects lenders from losses due to borrower default. In most cases, lenders require PMI for certain high-risk loans with lower than 20% down payment instead of requiring a larger down payment. The borrower pays for this coverage in monthly premiums added to the loan payment.

Understanding the biggest Components of a Mortgage - The Interest

Interest refers to the cost of borrowing your home loan. The majority of your monthly payment goes to paying off the interest. Your payment also reduces the principal, which is how you'll eventually pay off your loan. Still, most people make more interest payments than payments that reduce the principal.

Although this arrangement sounds good — "I can make all my payments and never have to worry about paying off my loan" — it's not good at all because you'll be paying more in interest than your house is worth, meaning that you could lose it if you have a foreclosure. Most homeowners want their house paid off as quickly as possible because they're essentially renting from themselves if it isn't.

There are two main types of mortgage interests: amortized loans and interest-only loans:

In an amortized mortgage, buyers typically make monthly payments that include principal and interest. Each month, part of your payment goes toward your principal balance, and part goes toward your interest balance. Interest-only loans

If you opt for an interest-only loan, you'll make monthly payments that are much lower than in an amortized mortgage (because you're not paying down your principal). These lower payments can be attractive to some buyers because they can free up more cash each month.

However, there's a catch: In most cases, you will have to pay back all remaining principal with one lump sum at the end of the loan term. And since you haven't been chipping away at it month after month, this lump sum can be very difficult to come up with.

Monthly payment

The monthly payment is the amount of money you have to pay regularly. It includes principal, interest, taxes, and insurance. Your monthly payment is not the same as your annual mortgage payment.

Mortgage payments are typically due once per month, with the exact date depending on your individual loan agreement terms. When the lender receives your mortgage payment, it applies a portion to interest, a portion to the principal, and escrow for taxes and insurance.

The remainder of each mortgage payment is used to reduce your total loan balance, making your home more valuable and reducing the amount of interest you will owe over time.

Choosing the right mortgage based on a monthly payment is one of the most important decisions a home buyer will make. The payment on your mortgage may be your largest monthly payment, but it's not just the size that matters—it's also the cost of each payment.

The only way to get an accurate picture of your mortgage costs is to look at all of its components. In addition to the principal and interest payments, other elements can affect your total costs.

For example, Mortgage insurance protects lenders against losses if homeowners default on their loans; however, it can add hundreds or even thousands of dollars per year to your mortgage payment.

How interest affects monthly payments

Let's assume that you have a 30 year fixed rate loan with a monthly payment of $1,000. You are looking at two other mortgages with different interest rates and terms. One has an interest rate of 7%, and another has an interest rate of 6%. Which one will cost more per month?

Interest Rate Monthly Payment 7% $1,000 6% $900. The higher interest rate costs more each month because it has a higher monthly payment.

How do you choose between fixed-rate and adjustable-rate loans?

Basic calculations show that a 1 percent increase in interest rate can increase your monthly mortgage payment by about 4 percent. In other words, if you have a $300,000 30-year adjustable-rate mortgage at 5 percent and rates rise to 6 percent, your monthly payment goes up by $100 per month or $1,200 annually. This may not seem much, but on a $300,000 home loan, it adds up to $60,000 in extra interest over 30 years.

How taxes and insurance can affect your monthly payments

The government assesses taxes at all levels. Insurance is provided by private companies that specialize in providing coverage for individuals or businesses.

Mortgage insurance helps protect lenders in case borrowers default on their mortgage loans. Mortgage insurance premiums are typically included in your monthly payment so that you don't have to come up with the money on your own.

Taken together, taxes and insurance can add several hundred dollars to your monthly payment. But that is not such a bad thing because they're very predictable costs — unlike your mortgage payment, which fluctuates monthly based on changes in interest rates.

Let's say your mortgage payment is $1,200 a month. And let's further assume that you live in the state of Illinois and will pay 6 percent tax on your monthly payments. Here's how your mortgage payment can be affected:

• Property tax - In Illinois, property taxes are 1.17 percent of your mortgage interest rate each year. So if your mortgage interest rate is 6 percent, you'll pay about 7 percent annually in property taxes.

• Insurance - Based on the type of insurance you buy, how much coverage you need, and where you live (which affects rates), insurance could cost anywhere from 0.25 percent to 1 percent of the average value of the home each year.

If you take out a $300,000 loan at 6 percent interest and live in Illinois, you can expect to pay about $890 per month for your mortgage plus about $150 for property tax, $50 for insurance, and another $400 for taxes.

Conclusion

Now that you understand the building components of a mortgage, you can tell exactly where every dollar goes in your loan. It becomes easier to eliminate waste and find ways to save money for the future. You'll see exactly how much of your hard-earned money is going toward interest instead of sinking into equity in your home. You might also discover ways to lower your interest rates and payments, which means more cash in your pocket every month!