How
Mortgages Work: Understanding the key
elements
A mortgage is simply a long-term loan from a bank,
thrift, independent mortgage broker, online lender or even the
property seller for the purchase of a home.
The property serves as the collateral for the loan. At
closing, the borrower gives the lender a lien against the house and
the land it sits on. The lien gives the lender the right to
foreclose on the home if the borrower doesn't adhere to the mortgage
payment arrangements.
Mortgages are repaid over long periods of time -
usually between15 to 30 years, though some lenders offer 40 year
mortgages. Monthly payments in the beginning are mostly made of
interest, only a small portion goes to the principal. Towards the
end of the loan, your payments will be mostly principal and a little
interest.
Your monthly payment includes several things. When
escrow is used, your monthly mortgage payment is referred to as
PITI. There are four parts to your PITI payment:
Principal - the loan balance
Interest - interest owed on that balance
Real estate taxes - the property taxes assessed by
your county, city or school district
Property insurance - insurance coverage against
fire, theft, damage or natural disasters
Many lenders require you pay your taxes and insurance
in escrow with your monthly mortgage payment. This way, the lender
is assured that your property taxes and insurance premiums are up to
date. Though rare, a few lenders will let you pay these expenses
yourself when they are due.
Depending on the type of mortgage you have, you may
have to pay private mortgage insurance as well.
The amount of the payment that goes towards principal
versus interest changes overtime due to a repayment formula called
amortization. This results in the lender spreading your interest
over the payments, keeping the monthly payments low.
For example, on a 30-year fixed-fixed interest
mortgage with an initial principal balance of $150,000 and a fixed
interest rate of 7.5%, the payment amount is $1,048.82 each month.
For the first 60 payments, over $880 of the payment goes to
interest, with less than $200 going towards the principal. But on
the last 60 payments, the majority of the payment goes towards the
principal - over $800 - while the rest is interest.
In total, the borrower will pay back $227,575.83 in
interest.
The majority of the interest is paid in the first
years to keep the payments stable. The spreading out of the interest
allows the borrower and lender to pay and receive a predictable
amount of interest over the life of the
mortgage.
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