Principal, Interest, Taxes & Insurance

The Principle & Interest Portion Of Your Monthly Mortgage Payment

Many people get confused about their monthly mortgage payments and how they are calculated?

It helps to understand that a loan is “amortized,” which means you will be paying it off over time, usually with monthly payments. The payments you make are set up to pay both interest and principal. When you have a fixed-rate mortgage, your payments stay the same over the life of the loan.

The meaning of “amortize” and “mortgage” both come from the Latin word “mort,” which means death. When you amortize your loan, you are basically killing off the debt. This is different from a loan that goes on indefinitely. A mortgage has a set term, and a length of time you are given to pay the loan off completely.

The formula for calculating the payment is not simple. The easiest way to estimate your payments is to use a mortgage calculator when you can enter several variables.

Understanding the interest calculation of your loan... Let’s look at an example loan amount yo explain this portion.

For a loan of $100,000, with a fixed interest rate of 4% for a period of 30 years, your monthly payment will be about $477. Most of this will go toward the interest in the early part of the loan. So, for example in your first $477 payment, $333 of the total would go towards interest and the remaining $144 will pay down the loan's balance.

This will make more sense if we look more at this example. With a $100,000 loan amount and a 4%, your interest rate that equals $4000/year in interest.  $4000 / 12 months = $333 which was the interest for the first month. After your 1^st payment the balance of your loan has been decreased by $144 which leaves a new balance of $99,856. Because the remaining balance is lower the amount of interest is also less and the balance of your payment that goes to pay off your loan is correspondingly greater. In fact, at the end of the first year you will owe $98,239 which means you would have only paid off $ 1,761 of the principal of your loan.

For many buyers, they are shocked to realize that they have paid almost 6,000 in mortgage payments yet paid off less than $2000 of their loan's balance. However, it does make sense because the lender needs to continue to get the interest on the loan's balance owed while also helping you to pay down the loan, in this example, over 30 years. With each year of payments, since your payment amount stays fixed, more and more of the payment will go to paying off the loan principal and less will be used to cover the interest. Again, this happens because with each passing payment, there is a little less remaining on the loan so there is less interest to pay. Again, since the interest payment decreases over time, and your payment amount remains constant, that means that with each subsequent payment you are paying off more of the principal then you did the prior month. After around 13 years of making payments this split between principal and interest will be almost equal, with about $235 going to interest and 242 going towards paying off the loan. Each year after that, a greater portion of your payment will go towards paying principal vs. interest.

If you have an interest only loan, then while your payment would stay at only $333, because the loan balance itself would never be decreased. Most lenders though will not allow this to continue for too many years. Usually, the lender will limit interest only payments to only five to 10 years. Then, once that 5 -10 years ends, typically your payments will increase so that you can pay off your loan over the next 30 years.

When you refinance a loan, you start over. Your 30-year term begins again, and you start again at year one, paying mostly interest with each payment.

With both a new mortgage and a refinance, typically your first mortgage payment will be due on the 1st day of the month, that immediately follows the month AFTER you closed. This happens because the interest is paid in arrears (after the fact) and it must accrue. So, if you close on the 25^th of April, typically your first payment would be June 1st which is the first of the month that follows the first compete month of May. In this example, at closing on the 25th, you will typically pay as part of your closing costs, the daily or prorated interest for the last 5 days of April which in this example would be April 25th to the 30th. You are prepaying this interest at closing since these days are not be covered by your first payment on June 1st that only pays the accrued interest only for the month of May.

Home Insurance

Unlike mortgage interest that is paid in arrears, (due at the end of a month,) Hazard or Homeowners insurance is paid in advance of the time being covered or service being provided. Lenders require this insurance to make sure that the property, which is collateral for the loan, is covered in case of a disaster like a fire or storm damage etc. You will typically pay for the first year of insurance as part of the closing or the lender will require you to provide a copy of the paid invoice showing you have already paid for a policy that covers the first year of the loan. Typically, lenders will also require you to “escrow,” (set aside) money into a separate "forced interest free savings account" with the lender. Lenders create this escrow account at closing and will typically include as part of your closing costs 2-3 months of for property homeowner insurance.

Then with your first mortgage payment, and every payment thereafter, the lender will collect from your total mortgage payment 1/12 of the annual insurance premium. This means that when the next insurance payment is due in a year after you bought the place, that the lender should already have the funds to pay for the insurance on your behalf and you do not get hit with a large payment at the end of this year.

If your down payment is 20% or more, then the lenders believe that you also have substantial risk in the property, and they may allow you to directly pay the premiums when they come due vs requiring you to escrow money for the lender to pay when these payments are due.

PMI/MIP... Private Mortgage Insurance & Mortgage Insurance Premium 

Private mortgage insurance (PMI), is typically required by a lender if your insured conventional loan-to-value ratio, the amount of the loan divided by the value of the home, is greater than 80%. Said another way this is typically required when your down payment is less than 20% of the purchase price. Note that this is calculated using the purchase price not the appraised value. So, even if the home should happen to appraise for more than you are paying, and the difference would seem to say you will have 20% or more equity in the property, you will still have to pay for PMI.

Mortgage Insurance Premium (MIP) is just like PMI but is required with FHA loans. With MIP and PMI this insurance protects the lender, not you as the homeowner, in case you default on the loan. Both PMI and MIP typically include an initial lump sum amount paid at closing along with monthly payment premiums that become a portion of your total mortgage payment. Most lenders have programs that allow you to increase the size of your loan to include your upfront MIP or PMI fees to minimize your closing costs.

Certain lenders with coventional loans also have PMI that can be paid ONLY in one lump sum at closing. The amount of payment will vary based on the size of the loan and your credit history, but the typical breakeven point is 2-3 years. This means that the amount you pay at closing as a 1-time amount is roughly equal to the combination of the smaller upfront payment at closing plus only 24-36 of your monthly PMI payments. The advantage to this is approach is that while your closing costs are greater you end up paying PMI for only 24-36 months vs the entire life of your mortgage.

With PMI you can typically remove this additional expense once the loan balance is equal to or greater than 80% of the value of the property. Conversely, with MIP the only way to discontinue MIP before the end of the mortgage term, is to refinance or sell your home.

Real Estate Property Taxes

Like mortgage interest, that is due at the end of a month, Indiana Real Estate Taxes are paid in following year and cover the taxes due in the prior year. Indiana requires two tax payments each year with one bill being paid in the spring and the other in the fall. The payment due in the spring covers the taxes due for the 1^st half of the prior year and the fall payment covers the taxes due for the 2^nd half of the prior year.

You will typically receive a credit (money) at closing for the property taxes for when the seller owned the property. Depending on when the next tax payment is due, relative to when you plan to close, the lender may require part of these funds, that would typically be given to you at closing by the seller, be paid directly to the taxing authority. Note: While these amounts paid to buyers by Seller’s will typically reduce the amount of money you need to bring to closing, the lender will need to know that you have enough funds to cover all of your closing costs WITHOUT including these credits or funds from the seller.

In the same way lenders want to pay for property insurance they also typically require that they pay the taxes on the property to help ensure the lender’s interest in the property is protected and the property is not sold to another owner at a tax sale due to unpaid back taxes. To deal with these twice per year payments in Indiana most lenders will require you to “escrow,” (set aside) money into a separate account with the lender to pay the real estate taxes when they come due.

Lenders will create this escrow account at closing and will typically include as part of your closing costs at least 2-3 months for property taxes. If the next tax payment due date is very close the lender could require 6-7 months of tax payment escrow at closing. One monthly payment is equal to 1/12 of the anticipated annual Real Estate taxes. Then with your first mortgage payment, and every payment thereafter, they will require you to pay another 1/12 of the annual insurance premium. That way, when the next insurance payment is due, the lender already has the funds in your escrow account to pay for the insurance on your behalf and you do not get hit with a large payment at the end of each year.

If you pay more than 20% down, then many lenders believe that you as the buyer also have a substantial risk in the property and they will allow you to pay the real estate taxes when they come due vs requiring you to escrow for this payment.