When purchasing a home these days, the most common mortgage that buyers take out is one that has a fixed interest rate over 30 years, though 15-year fixed-rate mortgages are becoming more popular. A mortgage will be paid down in equal monthly payments for the duration of the loan product period.
The loan is generally composed of:
- Principal — This is the amount you borrowed. Once your principal is paid off, you own the home outright.
- Interest — Interest is a fee paid to the bank based on your loan amount. Interest rates have been at historic lows and probably will remain low for some time. Currently, the average rate for a 30-year fixed-rate loan is about 3.5%.
The interest is charged on the amount of loan principal that remains every month, so in the beginning, a higher proportion of your monthly payment will be interest. As time goes on, your payments will be, proportionally, more principal and less interest. This payment process is called amortization.
For example, let’s look at a $400,000 loan with an interest rate of 3.7 percent and a total monthly payment of $1,841. In the first month, you’ll be paying interest on the full $400,000. This means $1,232 of your total payment will be interest, and you will pay down your principal by the difference: $609. The next month, you’ll be paying interest on the remaining principal or $400,000 – $609 = $399,391. The interest due will be slightly less than $1,232, and the principal paid will be more than $609. This trend continues for the duration of the loan, which is 360 months for a 30-year mortgage.
- Property taxes — On a $500,000 home in DC, total yearly taxes usually amount to about $3,000. This number varies depending on where you live. If your annual taxes were $3,000, you would pay $250 per month, and many banks wrap property tax payments into the monthly mortgage payment. Your lender will pay your tax the bill from the tax payments you’ve been making into your escrow account every month.
- Homeowner’s Insurance — This is a mandatory insurance policy that homeowners must take out on the full value of the property. Most lenders won’t issue a mortgage if the owner does not take out insurance. Similar to tax payments, many lenders will wrap your monthly insurance payment into your mortgage payment and then pay the insurance bill on a yearly basis.
Finally, you can always make mortgage payments that are larger than the set amount and pay off your mortgage sooner than the life of the loan, thus paying a smaller amount in total interest. However be sure to indicate the additional payment is to go toward paying off the principal loan amount. If you forget to do this, the additional payment will go toward interest that is due.
Partially reprinted from UrbanTurf.