Do you know exactly what you’re paying for when you pay your mortgage? Understanding your mortgage payment is very important and can help you buy a home with confidence.
So what does a mortgage payment consist of?
The principal of your mortgage is the balance, i.e. how much of the borrowed amount you are paying off. When you first start paying your mortgage, most of your payment is interest and a small portion is principal. Over time, however, you will gradually be paying more principal and less interest.
Speaking of interest, this brings us to the second component of a mortgage payment. We like how Investopedia explains interest: “Interest is the lender’s reward for taking a risk and loaning you money.” (emphasis added) Interest is, essentially, what lenders charge in exchange for their lending services. It’s a risk loaning money, so charging interest is a standard “fee,” so-to-speak, that everyone who borrows money has to pay.
Lenders charge interest based on whatever the current rate is. Depending on how many people are borrowing money at the time, the current market, etc. interests rates can be high or low. Higher interest rates are going to make your mortgage payment higher, and lower interest rates make your mortgage payment lower.
The third part of your mortgage payment is taxes. Your house will be assessed and, based on various factors, a tax will be determined by your local government. You do not pay the tax all upfront, though. Instead, lenders allocate an amount to be paid with each mortgage payment. Your lenders will set those taxes aside in an escrow account and pay them to the government when they are due.
The last “slice” of your mortgage payment is insurance. There are two types of insurance: homeowner’s insurance and mortgage insurance. You could be paying one or both of these, depending on what your financial situation is. What’s the difference between the two? Think of it in terms of who the interest is protecting. “While mortgage insurance protects the lender in case you default on your loan, homeowners insurance protects you in case your property gets damaged,” Chris Joseph of “The Nest” explains. The insurance portion of your mortgage payment is also set aside in an escrow account and paid when it is due.