Preparing to Buy a Home: Understanding Your Mortgage Payment

Everything You Need to Know About Your Monthly Mortgage Payment

Most people do not pay in cash for their first home. So it’s important to understand mortgage payments before buying a home. This article tells you what goes into a mortgage payment, how your mortgage payment reduces your loan balance, and how you pay off your home loan.

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What Is a Mortgage Payment?

When you borrow to buy a home, your lender advances you a sum of money to pay the seller. You then repay your lender in monthly installments. Your lender calculates a payment amount that will pay off your loan completely at the end of your loan term.

Each monthly payment is divided into two parts — the interest on your loan for the previous month and a reduction of your loan balance. The loan balance is also called the loan “principal” and your mortgage payment consists of principal and interest, aka P and I.

What Is Amortization?

Amortization is the process of paying off your loan balance. The terms “amortization” and “mortgage” come from an old English word meaning “to kill” and your goal for your mortgage is to kill it off and owe nothing on your house!

Here’s how it works: Suppose that you have a $300,000 mortgage at a 4% interest rate. Your monthly payment is $1,432.25. At the end of Month 1, the interest charged by the lender equals $1,000, and the rest of your payment — $432.25 — is subtracted from your principal balance.

In Month 2, then, your principal balance is $299,567.75. Because your balance is a tiny bit lower, your monthly interest is also lower. It’s $998.56 this time. That means more money goes toward reducing your principal balance — $433.69.

Over time, less of each payment goes for interest, and more goes toward reducing your principal balance. This is important to know, especially if you want to pay off your loan sooner and reduce your interest cost over the life of your loan.

How Do Lenders Determine Your Mortgage Payment?

How Do Lenders Determine Your Mortgage Payment?

Your mortgage payment depends on three things:

  • Loan amount
  • Loan term (years)
  • Interest rate

You can see how these factors interact with an online mortgage calculator.

  • Your payment increases if the loan amount or interest rate go up.
  • Your payment decreases when you choose a longer-term like 30 years and decreases when you choose a shorter repayment term like 15 years.

It’s important to understand this because it affects the affordability of your home loan. For instance, you might be able to afford a maximum of $1,000 P and I payment per month. You could borrow about $209,000 at 4% over 30 years. But if you find a 3.5% loan, you could borrow almost $223,000. If you choose a 15-year term at 4%, your maximum loan amount drops to about $135,000. But 15-year loan interest rates are lower — if you borrow at a 2% interest rate, you can finance just over $155,000.

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Other Parts of a Mortgage Payment

The P and I are probably just part of your mortgage payment because most lenders require borrowers to also pay their homeowner’s insurance and property taxes with their monthly P and I. That’s because they want to make sure that you pay these costs on time.

When the lender adds these amounts to your payment, they call it an “escrow” or “impound.” Lenders divide the annual amount of your taxes and insurance, divide it by 12 months, and add that amount to your P and I payment. The entire amount is called PITI for principal, interest, taxes, and insurance.

But Wait, There’s More

Mortgage insurance policies pay the lender if you default

Your mortgage payment might include even more than PITI. Borrowers who put less than 20% down on their homes usually also pay for mortgage insurance. Mortgage insurance policies pay the lender if you default (don’t pay your mortgage). And if you buy a home in a designated flood zone, you’ll also have to purchase flood insurance.

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