Your mortgage payment may actually be made up of four different costs.
When you borrow money to buy a home, you will have a monthly mortgage payment to make. But it may come as a surprise that your payment can actually be made up of four separate costs.
It's important to understand each of the individual components of your mortgage payment. That way, you'll be more informed about the total amount of money you're spending on housing. And you'll be better equipped to make decisions that help you cut the cost of homeownership and stay within your budget.
Here are the four costs that can make up your monthly mortgage payment.
Principal is the amount of money you borrow from a mortgage lender when you take out a loan. So if you get a $280,000 mortgage, your principal balance is $280,000. The payment you make toward the principal goes toward reducing your loan balance. For example, say you borrowed $200,000, and $1,000 of your monthly payment goes to principal. In that case, you would reduce the amount due on your principal and would owe $199,000 after making your payment.
Typically, when you start paying your loan, very little of the monthly payment goes to the principal. That's because the bulk of your early payments goes to interest, and most of the principal is paid off during the later years of your loan.
Still, over time, as you make principal payments, your loan balance will slowly drop. And your loan payment is structured so you pay off the entire principal balance over the repayment timeline (which is usually 15 or 30 years). If you make extra principal payments, you can accelerate this process and pay off your mortgage early.
Mortgage interest is a percent of your loan balance. You pay interest as a cost of borrowing from a lender. It's money that the bank gets to keep, and your interest payments do not reduce the principal balance you owe.
The higher your mortgage interest rate, and the more money you borrow, the more interest you'll owe each month.
When you own a home, you typically have to pay property taxes to your local municipality. These taxes are collected by your local government. But lenders often don't trust that you'll be able to come up with a large lump sum to pay those taxes and may require you to put money into escrow each month to cover the cost.
An escrow account is a dedicated account the lender holds for you where it collects the monthly money you pay and keeps it until the property tax bill is due. That way, the lender doesn't risk you losing your home to a tax lien, which would make it difficult for it to get repaid.
Your lender will figure out how much you'll owe in taxes, divide that amount by 12, and tack that amount onto your monthly mortgage payment. When you send in this money, it's put into your escrow account. Your property tax bill will be sent to your lender and paid from this account.
Homeowners insurance works much the same way as taxes, and you may be required to pay for it monthly along with your mortgage. Although insurance is paid once per year, lenders will divide the amount due by 12 and collect a payment for it each month. The money is also put into your escrow account and used by your lender to pay your insurance bill.
Lenders will take these four components of your payment -- principal, interest, taxes, and insurance -- into account when determining if you can afford a mortgage. You should also consider all of them to see how your loan will fit into your budget and to ensure you're making a smart financial choice when borrowing. To figure out how much you might owe in these categories, use a mortgage calculator to play around with the numbers -- that way, you won't get caught off guard when it's time to make your payments.
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