What this article is all about:
Mortgage Payment Overview
For most people, a home mortgage is probably the biggest loan they have and represents one of life’s largest commitments. Mortgage lending has been a staple of the housing market and a pillar supporting The American Dream. Yet, it can be an overwhelming and confusing process for many homebuyers.
This guide was created to help you through the basics of mortgages, and home financing. The idea is to give you the foundation to understand how the process works, what factors matter, common pitfalls, and useful resources.
You’re probably progressing along in your home search if you’ve found this article, so here’s the gist.
At the most basic level, your mortgage will include repayment of the purchase price for the house and interest on the loan. For a quick estimate of what your payment might look like, check out our mortgage calculator.
Most mortgage payments are more complex than the basics above, so keep reading for all the details.
P.I.T.I.: Principal, Interest, Taxes, and Insurance
Let’s start with the common components of a mortgage payment. In most cases, your payment will include some combination of the items described below, but variations do occur.
You may see P.I.T.I. commonly referenced as you begin to learn about mortgage payments. P.I.T.I stands for principal, interest, taxes, and insurance.
So what goes into your mortgage payment?
Mortgage Payment = Principal (amortized) + Interest (amortized) + Real Estate Taxes (pro-rated) + Private Mortgage Insurance (pro-rated)
Principal is the actual amount you borrowed from the lender, and the part of the mortgage you probably care about most. Every time you make a payment, your principal balance decreases, and your home equity – the value of the home in excess of the mortgage obligation – increases.
Interest is the other big chunk of your payment. Interest is accrued annually, as in Annual Percentage Rate, regardless of whether you have a fixed rate mortgage or an ARM. To figure out how much of your monthly payment is going toward interest, all you need to do is:
You’ll notice that, when you are just starting out, the majority of your mortgage payment goes to interest. But every month you pay down a little bit of principal as well. So when you calculate your payment the next month, you’ll notice a little bit less went to interest and a little bit more to principal.
This is basically how an amortization schedule works. Since the lender is mostly concerned with collecting interest in return for taking a risk on your loan, they balance the payments in a way that favors interest repayment in the initial years. It also helps stabilize the payments over the entire repayment term, ensuring that your monthly payment remains constant throughout.
Other factors can influence the balance of interest to principal in your payment, such as: changes to your interest rate (in the case of an ARM), re-financing, and lump sum payments toward principal.
But wait! That doesn’t add up for me.
Often times, mortgage payments include additional fees. Fees associated with the legal obligations of owning a home, like taxes and insurance, are generally wrapped into your monthly payment.
Private mortgage insurance (PMI) is necessary until you have paid down a sufficient amount of principal to own at least 20 percent of the equity in your home (percentage may vary depending on specific circumstances), or if you’re considered a credit risk. This protects the lender against default.
To ensure you keep the real estate taxes and PMI current, lenders typically set up an escrow account. The portion of your monthly mortgage payment associated with taxes and insurance will be held in escrow until it’s due, sometimes once a year such as with real estate taxes.
For instance, you may pay 1/12th of your total estimated real estate taxes each month as a part of your mortgage. This guarantees that when your payment is due, you have the money available.
Once you’ve paid down a certain percentage of your principal, lenders will generally let you begin paying taxes and insurance directly. Real estate taxes can fluctuate, especially in gentrifying areas, so you’ll probably want to set aside a portion of the payment monthly anyway.
In some cases, as part of closing, you may have to pay for a year’s worth of PMI upfront. The same is true for taxes; you may pay a pro-rated portion of your taxes at closing as well as a monthly portion. Arrangements vary depending on what’s customary in your market, as well as your lender agreement.
After you have lived in your home for a few years, check out your equity. Mortgage insurance isn’t cancelled automatically, although you are supposed to be notified when it is no longer required. Once you’ve paid enough toward principal, you can drop the PMI and lower your monthly payment. You’ll need to make arrangements with your lender.
Down Payments & Loan to Value (LTV)
These two components play a big role in determining your maximum mortgage loan amount, interest rate, and consequently your monthly payment.
The down payment is the amount you pay toward the principal value of the property. This helps determine your loan-to-value ratio. It also gives the lender confidence that, in the event of foreclosure, the value of the property can cover the remaining principal balance of the mortgage.
In general, you should attempt to provide the biggest down payment you can afford. The bigger the down payment percentage, the lower your interest rate will be and the easier it will be to secure a mortgage.
In some cases, a big down payment can even offer you the opportunity for a non-standard 15-year mortgage, or similar shorter repayment period.
This is not only advantageous from the perspective of an easier-to-secure lower interest rate, but because of the accelerated repayment plan you can literally save tens-of-thousands of dollars on interest over the life of your loan.
Loan-to-value (LTV) ratios represent the relative size of the mortgage, compared to the value of the home. This is important in determining both your interest rate, and your need for PMI.
Even small changes in interest rate can translate into thousands of dollars over the term of the loan. So, working to get the lowest LTV you can will save you money.
Debt to Income Ratio: Front End vs. Back End
Debt to income ratio is the primary calculation mortgage brokers and lenders will use to qualify your ability to repay the loan.
This is one of the most important numbers lenders will reference during the mortgage approval process. The lender will add up all your monthly obligations, including: student loans, insurance(s), bills, and credit card payments.
The total of your monthly obligations will then be divided by your gross monthly income. The resulting percentage represents the portion of your income that your debt constitutes. The lower the percentage, the more likely you are to secure a mortgage with good terms.
Most experts recommend that your debt-to-income ratio should be below 40 percent, so you can comfortably afford paying a monthly mortgage.
This is a great baseline when figuring out affordability, but definitely consider that this is based on your gross (pre-tax) income and does not take into account your tax liabilities, among other monthly expenses.
You should consult a licensed tax professional and/or an attorney to review the tax implications of owning a home.
The above formula is a good start, but lenders and brokers will generally take it a step further and calculate the “front” ratio (housing costs only), then compare that to your “back” ratio (including monthly consumer debt obligations).
This allows lenders to evaluate your information and creditworthiness with and without housing accounted for, as well as understand how much of your total monthly debt obligations are taken up by housing expense.
Mortgage experts say a healthy front-to-back ratio is about 33/38. That means that a borrower’s housing costs should consume no more than 33 percent of their monthly income.
Adding the borrower’s monthly consumer debt to the housing costs should amount to a maximum of 38 percent of monthly income, in order to meet sound mortgage payment requirements (or, in relative terms, 87 percent of your monthly debt is from housing).
Rationally evaluating your debt-to-income ratio can help prevent the purchase of your dream home from turning into an endless nightmare. Don’t agree to a “surprisingly generous” loan offer if you think you can’t handle it.
If the monthly payments will leave you with little gas, medicine or grocery money, or lacking a safety net in case of job loss – then it’s not the right deal for you.
Calculating Your Mortgage Payment
For the mathematically inclined, if you feel like building your own model, here’s how you get to the monthly mortgage payment for the principal and interest on a standard 30-year fixed-rate loan.
Now you can get a back-of-the-napkin mortgage payment pretty easily with our mortgage calculator.
If you want to get a more accurate estimate, so that you can understand how much your paying toward principal or interest, have the ability to project what will happen if you make various changes such as principal pay downs, then you will want to put together your own amortization table and calculator.
The first tool you will need is a spreadsheet program like Microsoft Excel. There are actually a lot of great, pre-configured templates available for mortgage calculation. You can simply search online, or visit the Microsoft Office templates site.
Most of the free templates will break down your base principal and interest payment over the life of the loan.
You will want more detail than that, so you need to account for real estate taxes (you should get the tax rate from the sellers agent, or local municipal website*) and mortgage insurance too. Those extras, the T.I. of P.I.T.I., are usually pro-rated annually. You will need to add a column for each of these in your spreadsheet, and make sure that value is added to the amortized mortgage payment.
What does pro-rated mean? Well, the main difference is that your tax and insurance are not a “debt obligation” and are interest free, so you are just taking the annual value of those two figures and dividing them evenly by 12 (monthly payments). That sum is then added on to your monthly mortgage payment.
Now you can see not just your monthly payment, but how much you will pay for the life of the loan, how much of it will go to interest (to the lender), how much of your payment goes to the components of P.I.T.I. each month and more.
With your own amortization table, you can also see what effects changes like interest rate adjustments or principal pay downs will have.
Some things you should consider:
Resource Center & Glossary
Key terms – in plain English
Adjustable Rate Mortgage (ARM) – A mortgage that has a fluctuating APR.
Amortization – A process that allows the repayment of the interest and principal of a loan in equal installments, but non-equal proportions, during a pre-determined repayment period.
Annual Percentage Rate (APR) – Interest that is calculated annually, based on the principal balance of the loan.
Borrower – The person, or entity, that is requesting the loan.
Debt – The responsibility to re-pay a borrowed amount at some regular interval. These can be both private, and unsecured, such as credit cards; or, they can be secured such as an auto loan. They can also be “public” or government obligations, such as student loans.
Debt-to-Income Ratio – The relative proportion of your debt compared to your monthly gross income.
Down Payment – A payment that reduces the principal value of the loan made during a home purchase.
Escrow – An account setup by your legal representative with a financial entity that holds your money, to be used for a pre-determined purpose.
Fixed Rate Mortgage – A mortgage that sets a single fixed interest rate, for the full term of the loan.
Gross Income – Your monthly income, before taxes and deductions.
Home Equity – The value of your home in excess of any principal owed on your mortgage.
Interest – The rate a lender charges to support the risk they inherit by issuing a loan.
Lender – The bank, or financial institution, that is issuing the loan.
Loan-to-Value Ratio (LTV) – The relative proportion of a loan compared to the appraised value of a property.
Lump Sum – A payment that reduces the principal value of the loan, made anytime after a home purchase.
Principal – The actual loan amount based on the purchase price of the home, less any down payment amount.
Private Mortgage Insurance (PMI) – Insurance that is required for certain mortgages, depending on the lender’s requirements.
Property Tax (Real Estate Tax) – The taxes assessable on real estate property. Commonly set at the county or municipal level.
Pro-rate – A function that takes a lump amount and divides it, proportionally, between some pre-set quantities of payments.
Refinance – A process by which a borrower and lender pay off the preceding mortgage loan and replace it with a new one based on the current principal value and any changes to interest rate.
Repayment Term – The number of years, or months, required to repay the full amount of a loan, including total interest payments due.