If you’ve been renting, you pay your landlord a certain amount every month. That amount covers your cost to live in your rental unit, but it may also include water, pet rent, reserved parking, electricity, waste services, and maybe even something for access to the onsite fitness center, all depending on your lease.
Fast forward a bit to when you may decide to get a house. At closing, your loan paperwork will contain a payment amount based on interest rate, loan amount, and the term of repayment. Your closing paperwork will also include a payment letter that gives you all of the who, what, and where of your first mortgage payment.
The amount on your payment letter includes principal and interest, but it may also include several other items such as homeowner’s insurance, mortgage insurance and property taxes.
This is often referred to as PITI (Principal, Interest, Taxes, and Insurance) and is an important aspect of the breakdown of your monthly mortgage payment.
Principal is the amount of your payment that goes towards paying down your loan amount. In the beginning of your loan repayment schedule, the principal part of your payment is kind of small, but it’s reducing your loan amount little by little each month.
Your lender gets paid for giving you the loan, and how they get paid is through interest. Your interest rate determines how much interest you will pay to the lender. That interest is spread out over the number of months you’re paying back your loan. Each mortgage payment has a portion that gets paid towards interest.
Before I jump into taxes and insurance, I’d like to share some insight on your amortization schedule as it pertains to your principal and interest (P&I) payment.
Although the total principal and interest payment is the same each month, the principal and interest distributions change over time as your loan amount gets paid down.
Your amortization schedule is the breakdown of how principal and interest is applied to your loan each month for the duration of your loan term (number of months of repayment.)
For example, let’s say you have a $100,000, 30-year (360 month) mortgage loan, with a fixed interest rate of 6%. Your total principal and interest payment is $599.55 every month.
For your first payment, $99.55 goes towards principal and $500.00 goes toward interest. Your original loan amount of $100,000 is now reduced to $99,900.45 after principal is applied.
For your second payment, you’ll still be paying $599.55 for principal and interest; however, now, your distribution is based on the loan amount of $99,900.45 and no longer on the $100,000. This means more of the monthly payment goes towards principal and less towards interest, as seen in the chart below.
This continues month after month until you reach a $0 balance on your loan. This helps explain how your P&I payments are applied to your loan. You’ll see this information on your monthly statement as well.
Real estate taxes are used to pay for schools, fire department services, police services, etc. within your community. You may owe these taxes annually, quarterly, or semi-annually. Instead of taking on the responsibility of saving money to pay these taxes as they come due, you can establish an escrow account with your lender who sets aside a portion of your total payment each month into that escrow account. When the bill is due, your lender pays it on your behalf out of your escrow account.
Each mortgage payment will contain 1/12th of the total annual bill amount and is adjusted annually to make sure you are paying the right amount towards your tax bills. But keep in mind, your lender has no control over the amount of taxes you owe.
The last piece of your monthly payment is insurance. Like with your taxes, you can have your lender set aside a portion of your total monthly payment into your escrow account for homeowner’s insurance payments and then pay them on your behalf as they’re due. It’s important to note that you select your insurance company and policy, so your lender has no control over the premiums. Your lender will receive copies of your insurance bills and will pay them for you, but does not negotiate lower rates or premiums for you.
If you’re required to have mortgage insurance, the monthly premium is also included in your total payment amount.
Now, let’s address some additional questions you may have about your monthly payment.
Utilities, homeowner’s association fees, and condo association fees are not included in the mortgage payment that you pay to the lender.
You’re responsible for setting up your utility accounts and paying those separately. If your home is part of a homeowners’ association (HOA) or condo association, you will receive paperwork from the association with payment information. If you’re not in a flood zone that requires flood insurance, but you opt to have a policy, this will not be escrowed. If you’re required to have flood insurance and your lender is escrowing the regular taxes and insurance, flood will be escrowed too.
Yes you can pay extra, but there may be fees associated with early pay off.
Check your loan documents for a clause called pre-payment penalty. It will tell you up to how much of your loan balance you can pay off each year without incurring a fee.
You may be able to send additional towards principal and even towards your escrow account. If you’re like me, you like paying nice whole amounts each month and those extra few dollars and cents here and there can add up.
As we mentioned in a previous article about private mortgage insurance, paying extra towards principal may even help get the private mortgage insurance removed from your loan sooner.
If your mortgage payment changes due to increases in taxes and insurance, you’ll receive a letter before the changes occur so that you can adjust your budget accordingly.