If you’re buying a house, especially for the first time, the mortgage process can seem confusing. How is the payment calculated? What is escrow? What is PMI? Here’s a quick guide to help you understand.
Of course, your payment has two components: principal, or the original amount that you borrowed, and interest. If it’s a fixed rate of interest, that rate is applied to the principal each month to determine the interest portion of your payment. The rest is principal. This is how your payment is the same from month to month, but the interest and principal portions of the payment change each time.
If you’ve had your mortgage for a while, you might have gotten a statement showing your principal balance and been shocked that the principal has been reduced only slightly, despite a year or so of faithful payments. But, if you consider how interest is calculated, this makes sense. As was noted earlier, interest is applied to the principal balance to come up with the interest component of your payment, with the rest going to principal. So, at the beginning of a fixed-rate mortgage, that interest is the bulk of that fixed payment amount, with a minimal amount going to principal. This also ensures that the lender makes back his interest while you are still paying down the principal balance of your loan. As time goes on, however, the share of each payment attributed to principal gets larger and larger, and this is how your loan gets paid off. At the end of the loan amortization, virtually the entire payment is principal.
You can speed up this process a little by adding a little extra in each payment to go to principal, signing up for a pre-payment program, or just sending in an extra payment or two every year.
Most monthly house payments aren’t just principal and interest, however. You have taxes and various insurance policies to pay, and these tend to be rolled into your payment by the bank. That’s why you might see an “escrow” component to your payment. The bank figures up the total amount that it expects to need for the coming year’s homeowners insurance and property taxes, then divides that amount by the total mortgage payments for the year. When the homeowners’ insurance and tax bills come due, they go to the mortgage company, who pays them for you using the escrow that has accumulated.
You might also see an amount for PMI, or Private Mortgage Insurance, on your mortgage statement. PMI is required if the amount of your mortgage loan is comparatively high versus the fair value of your home. In other words, you have very little equity built up in your home. PMI usually applies if the down payment you make is a small percentage of the actual mortgage. So, the PMI is an insurance policy that ensures the lender will be protected in the event you default on your mortgage. Once you’ve made enough payments to accumulate enough equity, the PMI policy should be cancelled automatically – but since a lender can always make a mistake, check regularly to ensure that you are still required to pay for it.
One more important note: If you have an adjustable rate mortgage, or ARM, understand that the interest rate can change – sometimes significantly – making for a major change in the amount of your payment. Know what kind of mortgage you have and, if it’s an ARM, understand how high the interest rate can go, and how often it can change
A mortgage can seemed complicated, but hopefully your monthly mortgage statement is now demystified. Check your statements regularly, and don’t be afraid to ask questions about anything you don’t understand. A home is your life’s biggest investment, and you should know where every penny of that payment is going.