In simplest terms, a mortgage is a long-term
loan designed to help the borrower purchase a house. In addition to repaying
the principal, the borrower is obligated to make interest payments to the
lender, and the home and the land around it serve as collateral. But if you are
looking to purchase a house, you need to know more than these generalities. In
this article, we'll look at how a mortgage functions and how it is paid off.
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.
While it may seem like mortgages have always
been available, the modern mortgage came into being only in 1934, when the
government, in an effort to help the country overcome the Great Depression,
created a mortgage program that minimized the required down payment, thereby
increasing the amount that potential homeowners could borrow. Before the
creation of this mortgage program a 50% down payment was required to purchase a
home. Today, a 20% down payment is desirable (as it minimizes private mortgage
insurance (PMI) requirements), but there are mortgage programs available that
allow significantly lower down payments.
Mortgage Payments
The primary factors determining your monthly
mortgage payments are the size and term of the loan. 'Size' refers to the
amount of money borrowed and 'term' refers to the length of time within which
the loan must be fully paid back. There is an inverse relationship between the
term of the loan and the size of the monthly payment: longer terms result in
smaller monthly payments. For this reason, 30-year mortgages are the most
popular mortgage type.
PITI: The Components of a Mortgage
Payment
Once the size and term of the loan have been
determined, there are four factors that play a role in the calculation of a
mortgage payment. Those four items are principal, interest, taxes and insurance
(PITI). As we look at these four factors, we'll consider 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 small and increases
with each mortgage payment. While the mortgage payments in the first years
consist primarily of interest payments, the payments in the final years consist
primarily of principal repayment. For our $100,000 mortgage, the principal is
$100,000.
Interest
Interest is the lender\'s reward for taking a
risk and loaning money to a borrower. 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 further reading on different types of mortgage
interest rates see Mortgages: Fixed-Rate versus Adjustable-Rate.) So, for most
home buyers, higher interest rates reduce the amount of money they 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.
Taxes
Real estate taxes are assessed by governmental
agencies and used to fund various public services such as school construction
and police- and fire-department services. Taxes are calculated by the
government on a per-year basis, but individuals can pay these taxes as part of
their monthly payments. The amount that is due in taxes 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 are due to be paid.
Insurance
There are two types of insurance coverage
which may be included in a mortgage payment. Like real-estate taxes, insurance
payments are made with each mortgage payment and held in escrow until the bill
is due. The first type of insurance is property insurance, which protects the
home and its contents from fire, theft and other disasters.
The second type of insurance is PMI (mentioned
above), which is mandatory for homeowners who purchase a home with a down
payment of less than 20% of the home\'s 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
comprise a typical mortgage, some borrowers opt for mortgages that do not
include taxes or insurance as part of the monthly payment. With this type of
loan, borrowers have a lower monthly payment, but must pay the taxes and
insurance on their own.
How Mortgages Work: the Amortization
Schedule
A mortgage's amortization schedule provides a
detailed look at precisely 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, as it gradually moves toward
the principal becoming greater.
In our example of a $100,000, 30-year
mortgage, the amortization schedule consists of 360 payments. The partial
amortization schedule shown below demonstrates how the balance between principal
and interest payments reverses over time as later payments consist primarily of
principal.
As the chart shows, each of the required payments is $599.55, but the amount dedicated toward principal and interest varies from payment to payment. Because of the inverse relationship between principal and interest paid, at the start of your mortgage the rate at which you gain equity in your home is much slower. This demonstrates the value of making extra principal payments if the mortgage permits pre-payment. Each extra payment results in a larger repaid portion of the principal, and reduces the interest due on each future payment, moving the homeowner toward the ultimate goal: paying off the mortgage.