A mortgage is a loan from a lender (typically a bank) that allows you to purchase a home. Your monthly payments include a combination of the loan principal, interest and property taxes and insurance.
A mortgage may include a clause that allows the lender to take your house if you don’t make the payments. Your lender also manages the property taxes and homeowners insurance associated with your loan through an escrow account.
Affordability
Buying a home with a mortgage is the biggest debt most people will ever take on. If you fail to make your payments, the lender can take your property and sell it to recover their money. To avoid this, it is important to focus on mortgage affordability, which depends on your income and other priorities.
To determine how much house you can afford, a lender compares the amount of money coming in to the expenses going out. This is known as your debt-to-income (DTI) ratio. In general, lenders prefer a DTI of 30% or less.
To calculate your DTI, add up all your recurring monthly debt payments, including car loans, minimum credit card payments and student loans. Then, divide that number by your gross monthly income. This is the amount you should aim to spend on your housing expenses each month. However, if you have compensating factors, such as an excellent credit score or cash reserves, you may be able to qualify for a higher DTI. Our mortgage affordability calculator can help you find the right number for you.
Payments
Most mortgage loans are repaid over time. As you make payments, the amount of principal decreases and your equity increases. If you miss payments, lenders can penalize you in a variety of ways.
Typically, mortgage payments are made automatically each month and are withdrawn from the borrower’s checking account. This makes it easier for borrowers to avoid paying late fees and damage to their credit score.
Four main components make up most mortgage payments: loan principal, loan interest, property taxes and homeowners insurance. Most mortgages use the acronym PITI to reference these four components.
Your mortgage payment includes property taxes that are charged by local jurisdictions based on the value of your home. These taxes help to fund road repair, public schools and fire departments. Most mortgages include a one-twelfth of your estimated annual real estate taxes in your monthly payment and put it into an escrow account. This allows your lender to pay your property tax bill on your behalf when it comes due.
Some mortgage loans require a large, lump sum “balloon” payment at the end of the term. This is often required in order to keep the loan at a certain level of interest, even if you are paying the principal down over time.
Interest
Mortgage interest is the amount of money you pay to your lender for using their funds to purchase a home. It is calculated as a percentage of the principal balance. Your credit score, debt-to-income ratio, down payment size and other factors affect your ability to obtain a loan at a low interest rate.
There are two types of mortgages: fixed-rate and adjustable. Fixed-rate mortgages have an interest rate that stays the same for the life of the loan, while adjustable-rate mortgages have rates that change under defined conditions. Your lender may also collect a portion of your monthly mortgage payments in an escrow account to pay property taxes and homeowners insurance.
You can find out how much your monthly mortgage payments will be by entering the principal and interest amounts in our calculator. The calculator also estimates property tax and homeowners insurance, which you can edit if necessary. Mortgage rates vary based on many factors, including economic trends that influence investor demand for mortgage-backed securities. You can lower your mortgage interest rate by paying “discount points” upfront, but this might not make sense if you plan to sell your home soon.
Taxes
Property taxes are a regular expense of homeownership and can be rolled into mortgage payments by some lenders. When this is the case, the lender sets the money aside in an escrow account and makes monthly withdrawals to pay the tax bills. The fees associated with obtaining a mortgage, including third-party closing costs and appraisals, are usually separate from property taxes.
Mortgage interest is also tax deductible, which reduces households’ taxable income and decreases the amount they need to pay in taxes. This is an incentive for many homebuyers. However, proposals are being considered to change the MID, which could affect homeowners’ deductions.
If you’re refinancing, consider a mortgage assignment to transfer the original mortgage recording tax to the new lending institution. Make sure to pay the mortgage recording tax promptly; states can charge monthly penalty fees and impose a floating rate of interest on unpaid documents. You may be able to save on this fee by purchasing mortgage points, which are prepaid interest. These are tax-deductible in the year they’re paid. Purchasing these upfront can reduce your mortgage’s interest rate by a percentage point or more.
Insurance
Many mortgage lenders require borrowers to have homeowners insurance, which protects the lender and borrower against property damage or loss. Typically, the lender will collect the premiums as part of your monthly mortgage payment and place them in an escrow account. Then, the lender will pay the premiums to the insurance provider when they are due.
Your lender may also offer mortgage protection life insurance to protect the lender in the event you die while still owing on your loan. This type of insurance pays the lender or your heirs, depending on the terms of the policy.
Mortgage insurance is a financial product that mitigates risk for the lender and allows them to lend money to more homebuyers. It is most often required on conventional loans when the borrower makes a down payment of less than 20%.
Different types of mortgage insurance exist, and the cost, requirements and frequency vary by loan type. For example, private mortgage insurance (PMI) is commonly required on conventional loans with down payments of less than 20%; mortgage insurance premiums (MIP) are common on FHA loans.
