Do You Really Know Where Your Mortgage Payments Go?

Do You Really Know Where Your Mortgage Payments Go?

When you buy a home, you are primarily concerned about the total mortgage payment you will have to make.  Few homeowners truly understand how the payment is broken down by the mortgage company.  All mortgage payments have at least two parts.  Most have four parts and a few have many ways the payment is distributed.

Principal and Interest

The interest paid to the mortgage company is the largest part of your payment in the early years.  Mortgages are generally amortized loans.  What that means is the loan is scheduled into periodic payments of both principal and interest.  Since the balance of the principal is largest at the beginning of the loan, a larger portion of the payment goes to pay interest and does not reduce your principal by  much.

As you make payments over the life of the loan, the portion of each payment going to pay down your principal increases.  In the typical 30 year mortgage, the principal payments exceed the interest portion during year 18.  Most mortgage companies will allow homeowners to pay additional money to reduce the principal.  Making extra payments toward the principal can greatly reduce the total cost of your loan.

Taxes and Insurance

This portion of your monthly payment allows you to pay these obligations over the full year by dividing the total of your taxes and insurance by 12.  If you gave less than 20% down, the mortgage company probably requires you to pay for taxes and insurance with this method.

Money is kept in an escrow account as it accumulates through the year and the lender is responsible for making the payments when they become due.  The mortgage company requires this control over payments for one primary reason…to reduce the risk of someone getting in trouble with taxes and insurance and jeopardizing their interest in your home.

Mortgage Insurance

When a borrower puts less than 20% of the purchase price down on a home, they will typically have to pay for mortgage insurance.  Although the name for this insurance varies with the program selected, mortgage insurance is designed to protect the lender, not you.  If a borrower falls behind on their payments, the primary lender knows they are covered for the for the financial loss up to the amount of the insurance coverage. 

With a conventional loan, a separate company offers PMI (Private Mortgage Insurance) to the borrower.  The borrower pays for the PMI and it normally paid monthly with only a small initial payment required at closing.   For an FHA loan (Federal Housing Administration), FHA is the entity offering the insurance coverage.  FHA mortgage insurance includes an upfront fee which is paid as part of your closing costs and also a monthly fee each month.  Other loan programs like a USDA (US Department of Agriculture) and VA (Veterans Administration)  have similar programs with different names.  Each program functions a little different, but the main reason for this type of lender coverage is to allow people to become homeowners – even if they cannot save the 20% down payment the mortgage company needs to underwrite the loan.

An alternative to mortgage insurance is a second mortgage also called a “piggyback” second mortgage.  They may be called a 80-10-10 or some other combination.  Be sure to investigate the total cost of all loan programs before you apply for your mortgage.  Understand the cost, benefits and options of each program.