A Simple Explanation for how a Mortgage Works
It is an exciting day. You have found your dream house and submitted the paperwork for your mortgage to the lender. Many people have mortgages but don’t understand what a mortgage is or how a mortgage works.
In simple terms, a mortgage is a loan. The mortgage lender advances you a sum of money to purchase a home. The lender holds an interest in the home until you pay off the mortgage. In effect, the mortgage lender is your partner in the purchase of the home.
Mortgages come in a wide variety of types and styles. However, most mortgages share several common traits and requirements. Before you sign a mortgage agreement with your lender, it is in your best interests to understand some of the terminology and the mechanics of home mortgages.
What is a Mortgage?
A mortgage is a loan. Almost all financial institutions offer home mortgages. Banks and credit unions are where most people look for their mortgages. More and more companies now specialize in just making mortgage loans. Like anything else, it pays to do a bit of shopping when seeking a mortgage loan.
Typically, mortgages are the largest loans that most individuals will ever make. A home can cost hundreds of thousands of dollars. Very few of us have the cash to make that kind of purchase.
The mortgage loan company loans you most of the money to buy your home. The loan amount is usually eighty percent of the value of the home. You are responsible for the other twenty percent of the purchase price.
The mortgage company holds an interest in your home as collateral for the mortgage. As the lienholder, the mortgage company has a say in some things about your home.
Where Does the Money Come from in a Mortgage?
Many people think that the money for most mortgages comes from the institution that took their application and, in turn, funded the purchase of their new home. In years past, this was the way a home loan worked. Before 1930, home mortgage loans were rare. Only the affluent could persuade a bank to make a loan to purchase or build a home.
Today, most home mortgage loans come from one of three government-managed lenders. You may make payments to a servicing institution, but the actual money that went to the seller of your home came from one of these funding organizations.
- Fannie Mae – Also known as the Federal National Mortgage Association or FNMA
- Freddie Mac – The shorthand term for the Federal Home Loan Mortgage Corporation or FHLMC
- Ginnie Mae – The Government National Mortgage Association or GNMA
No matter what lending institution you chose, in the end, one of these three lending institutions is the source of the funds. Your lending institution bundles or packages your loan with many other mortgages and sells these packages or pools to one of the three government lending organizations.
The lending institution gets another lump of money to make more loans, and the pooled mortgages become mortgage-backed securities which are traded much like stocks on Wall Street. These mortgage-backed securities don’t carry any ownership in your home. The original lender keeps that ownership interest until you pay off the mortgage.
What is PITI?
You will undoubtedly come across the acronym PITI as you look through your mortgage documents. PITI is a lending industry term that describes four parts of a mortgage. These four parts are:
- Principal
- Interest
- Taxes
- Insurance
Each of these parts of PITI affects your total payment. Before you accept any loan agreement, it is imperative that you fully understand the four parts of PITI and how they work together as you begin to pay off your mortgage.
Principal
The principal of your home mortgage is the total amount of money you borrow from the lender to purchase your home. For example, if you agreed to pay $200,000 for your home and agree to make a twenty percent down payment, you are expected to pay $40,000, and your lender will provide the other $160,000. The principal of your mortgage, in this case, will be $160,000.
The amount you pay to the lender to repay this principal is part of your monthly payment. Early in your mortgage, this amount looks like a pittance. As you continue to make payments, the principal payment will grow as the interest payment shrinks.
Part of the loan package that you get from your lender includes a mortgage amortization schedule. The amortization schedule shows each payment due for the life of the loan. The schedule will also show how much interest and principal you pay with each payment.
All mortgage loans allow you to make additional payments during the loan. If you make an additional payment, you can request that the payment applies to the loan principal. The net effect of making additional principal payments is to pay off your loan faster.
Interest
Nothing comes without a price. A home mortgage is no different. The mortgage loan company expects you to pay them for allowing you to use their money to buy your home. This payback comes in the form of interest on the loan.
If you did your homework before accepting a mortgage loan offer, you shopped around for the best interest rate. Rates do vary, and different lenders have different rate structures. Interest rates are a critical part of the whole loan package. For example, look at this comparison.
| Mortgage Payment Comparison | 3.5 percent mortgage rate | 4.0 mortgage rate |
|---|---|---|
| Mortgage Principal | $300,000 | $300,000 |
| 20 percent down payment | $60,000 | $60,000 |
| Length of Loan | 30 years | 30 years |
| Interest Rate | 3.5 percent | 4.0 percent |
| Principal and Interest per month | $1,077 | $1,145 |
| Total Payback over 30 years | $387,720 | $412,200 |
That measly half percent of interest will cost you an additional $24,480 throughout the 30-year mortgage. It pays not to ignore the pennies when you are trying to save dollars.
Taxes
The adage that nothing is certain in life except death and taxes holds true for your mortgage. As part of your monthly mortgage payment, you will pay into an escrow account. The escrow account is a way for the mortgage company to ensure that the taxes are paid on time as they are due each year on your home.
Many homeowners view this escrow amount as more of a service than a liability with their mortgage payment. The mortgage company pays the taxes each year (and the insurance premiums) when they are due. An escrow account makes one less thing that most homeowners must worry about each year.
Insurance
Your mortgage agreement makes it mandatory for you to maintain a certain level of homeowners insurance on your home. Insurance is for the protection of the mortgage lender as much as it is for you. In a catastrophic loss, the mortgage company knows that at least a portion of their investment in your home is protected.
Each month a portion of your mortgage payment is placed into the escrow account, and when the insurance premium is due, the mortgage company makes the payment.
You are responsible for choosing the insurance company, but the mortgage company’s name is on the policy as the lien holder. A listed lienholder on the policy ensures that any insurance claim includes their name and preserves their rights.
What is an Escrow?
During the process of purchasing a home, escrow can have two meanings. Understanding the differences between these two kinds of escrow is important.
- Good Faith Escrow – When you make an offer on a new home, a good faith deposit accompanies the offer to show your seriousness. The money goes to an escrow agent who holds the money until you meet the conditions of the agreement. The home sale is the usual point when the escrow agent releases the funds back to the buyer.
- Mortgage Escrow Account – Once the sale is complete and you take possession of your home, the mortgage company will set up an escrow account. A portion of each month’s payment goes into this account to pay taxes and insurance on your behalf.
Most mortgage companies audit your escrow account annually. The audit looks at several things.
- The amount of money in the account to make sure that there is an adequate reserve
- The auditors look at the history of payments for taxes and insurance premiums. If the audit shows that too much or not enough is collected each month, your mortgage payment will be adjusted accordingly.
- In some cases, if too much money is in the escrow account, the mortgage company may authorize a refund.
Most homeowners look at the escrow account as more of a benefit than an expense. In any case, insurance and taxes must be paid on time. Having the mortgage company collect these monies and make the payments is one less detail a homeowner must manage.
What is Amortization on a Mortgage?
Amortization of your home loan is simply the method the lending agent calculates your monthly payment. In general, mortgages and auto loans feature a variable amortization schedule. This type of amortization keeps your monthly payment the same but gradually changes how much of each payment goes to principal and interest.
As an example, take a 30-year $100,000 mortgage with a 4.5% interest rate. The monthly payment for this loan would be $507.
- The first payment on this loan would break down so that $375 went to pay the lender interest, and $135 would go to reduce the principal.
- When you make the last payment at the end of the 15th year of the mortgage, your $507 payment will divide into $249 to interest and $258 to the principal.
- When you make your last mortgage payment, $2 will go to interest, and $505 would go to pay off the principal.
The amortization process loads the monthly payment in favor of the lender. The lender gets paid the interest on the note faster than you reduce the principal. To even out this disproportionality, many homeowners make extra principal payments.
What Happens if I Pay an Additional $200 a month on my Mortgage
If you elect to make an additional $200 per month on your mortgage, it can have the effect of shortening your mortgage over time. Suppose your mortgage agreement allows you to make additional payments toward the principal of the mortgage. In that case, this is an excellent strategy for increasing the equity in your home and reducing the amount of interest you pay to the lender.
How Much is the Monthly Payment on a $300,000 Mortgage?
The monthly payment for principal and interest on a $300,000 mortgage is dependent on the interest rate and the escrow payment. Escrow amounts for taxes and interest are almost impossible to estimate. However, you can calculate the principal and interest payments using any of the many calculators available on the internet.
| Interest Rate | Principal and Interest Payment |
|---|---|
| 3 Percent | $1,011 |
| 3.5 Percent | $1,077 |
| 4 Percent | $1,145 |
| 4.5 percent | $1,216 |
Navigating the Path to a Mortgage
Finding your way through through a home mortgage takes you into some unfamiliar territory. You will learn a new vocabulary and new acronyms as you work toward your goal of a new home. The process may seem unfamiliar and confusing, but it is a relatively straightforward process once you master some technical jargon.
