Why Is Your Monthly Mortgage Payment Higher Than Just Principal and Interest Payments?

Don't be surprised to see a bigger bill as a homeowner.

When you are looking at a house and you plan to take out a mortgage to buy it, you'll want to know how much your monthly payments will be. This is crucial to ensure that your housing costs will fit comfortably within your budget.

You may be surprised to discover, though, that your mortgage lender will want to collect more money from you each month than it costs to just pay off your principal balance with interest. 

In fact, your monthly payment made to your mortgage lender could often be much higher than the cost of your loan alone. Here's why that's the case.

Lenders may collect money for other things

Although it may come as a surprise to new home buyers, mortgage lenders often go beyond just collecting money to pay down your loan.

In many cases, lenders require homeowners to pay in a certain amount of extra money each month in order to cover key housing expenses such as property taxes and insurance. The reason for this is because the home is collateral for the loan, securing the lender's interests. And the lender wants to make sure it protects that collateral. 

Typically, property taxes and insurance must be paid one time per year. Lenders worry that people won't be able to afford to cover hundreds or even thousands of dollars in costs when the bills come due. This could lead to an insurer dropping coverage or to a tax lien on the property. In either of these circumstances, this puts the lender at risk of losses. 

Rather than hoping borrowers will be responsible and save over time to pay for property taxes and insurance, lenders generally divide the annual cost by 12 and require homeowners to pay that extra as part of their mortgage payment each month. The money is then put into an escrow account where it sits and waits. When the property tax bill or insurance bills come, the lender will take care of paying them for you rather than you having to do it directly. 

To understand how this works, say you have a monthly principal and interest cost of $2,000. This would obviously be part of your monthly payment. But if your property taxes were $5,000 per year and your insurance cost another $1,000, then lenders would divide this $6,000 by 12 months and add $500 onto your required monthly payment. 

Your total monthly check you send to your lender would be $2,500 -- $500 of which was put into an escrow account to pay your other housing bills.

Should you waive escrow?

If you do not want your required monthly payment to be higher to force you to save over time for property taxes and insurance, you may have the option to waive escrow. This would mean you opt out and agree to just pay the tax and insurance bills yourself rather than sending extra money to your lender -- who then turns around and gives it to the insurer or county assessing the property tax. 

Many banks charge a fee for opting out of escrow, or impose strict requirements for who is eligible to do so because they want to make sure you actually pay your premiums and tax bill as promised. But it may be worth paying this if you want to cover your premiums and property taxes on your own terms rather than sending a lender money each month to put toward them. 

Just remember, though, that if you waive escrow, you absolutely must be sure to pay your bills -- so you may want to save in your own account throughout the year to do so.