A mortgage is a long term loan that a borrower
obtains from a bank, independent mortgage broker, online lender,
or even the property seller. The house and the land it sits on
serve as collateral for the loan. The borrower signs documents
at closing time giving the lender a lien against the property.
If that borrower doesn't make payments as agreed, the lender can
take the home through foreclosure. Because mortgages are such large
loans, consumers pay them off over long periods, usually 15 to
30 years. Their monthly payments gradually whittle away the principal
balance, slowly at first then rapidly toward the end of the loan.
When escrow is used, a monthly mortgage payment is called a PITI payment.
That's because each one covers a portion of the following four costs:
1. Principal: the loan balance
2. Interest: interest owed on that balance
3. Real Estate Taxes: taxes assessed by different government agencies
4. Property Insurance: insurance coverage against disasters
Borrowers can choose to pay their real estate taxes and insurance in lump
sums when they come due, rather than in monthly installments to their escrow
accounts. Depending on the kind of mortgage a borrower has, the monthly
payment may also include a separate levy for private mortgage insurance
(PMI) or government backed mortgage insurance premiums.
The breakdown of each payment changes over time because mortgages are based
on a repayment formula called amortization. This simply means the lender
spreads the interest you owe on the mortgage over hundreds of payments
so that the overall loan is as affordable as possible.
Here's how principal and interest change over the life of a loan
On a 30 year $150,000 mortgage with a fixed interest
rate of 7.5 percent, a homeowner who keeps the loan for the full term will
pay $227,575.83 in interest. The lender can't possibly expect that person
to pay all that interest in just a couple of years so the interest is spread
over the full 30 year term. That keeps the monthly payment at $1,048.82.
However, the only way to keep the payments stable is to have the majority
of each month's payment go toward interest during the early years of the
Of the first month's payment, for instance, only $111.32 goes toward principal.
The other $937.50 goes toward interest. That ratio gradually improves over
time, and by the second-to-last payment, when we're all driving hovercars
and have colonized the moon, $1,035.83 of the borrower's payment will apply
to principal while just $12.99 will go toward interest.