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.
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. (For more on PMI, see Understanding Your Mortgage.)
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.
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 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. (To get an idea of what monthly payment results from a particular principal and interest rate, see this calculator.)
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.
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.
A mortgage is an important tool for buying a house, as it allows individuals become homeowners without making a large proportional down payment. However, when you take on a mortgage, it's important to understand the structure of your payments, whose components are dedicated not only to the principal (the amount you borrowed), but also interest, taxes and insurance. This structure determines how long it will take to pay off the mortgage and, in turn, how expensive it will ultimately be to finance your home.
(For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subprime Mortgages Feature.)