The primary factors determining your monthly mortgage payments are the size and term of the loan. “Size” refers to the amount of money borrowed and “term” refers to the length of time within which the loan must be fully paid back. There is an in-verse relationship between the term of the loan and the size of the monthly payment. Longer terms result in smaller monthly payments. For this reason, the most popular mortgage term is 30 years.
Once the size and term of the loan have been determined, there are four factors that play a role in the calculation of a mortgage payment. Those four items are principal, interest, taxes, and insurance (PITI). As we look at these four factors, we’ll consider a $100,000 mortgage as an example.
A portion of each mortgage payment is dedicated to repayment of the principal. Loans are structured so the amount of principal returned to the borrower starts out small and increases with each mortgage payment. While the mortgage payments in the first years consist primarily of interest payments, the payments in the final years consist primarily of principal repayment. For our $100,000 mortgage, the principal is $100,000.
Interest is the lender’s reward for taking a risk and loaning money to a borrower. The interest rate on a mortgage has a direct impact on the size of a mortgage payment: higher interest rates mean higher mortgage payments. So for most homebuyers, higher interest rates reduce the amount of money they can borrow and lower interest rates increase it.
Real estate taxes are assessed by governmental agencies and used to fund various public services such as school construction, police, and fire department services. Taxes are calculated by the government on a per-year basis, but individuals can pay these taxes as part of their monthly payments. The amount that is due in taxes is divided by the total number of monthly mortgage payments in a given year. The lender collects the payments and holds them in escrow until the taxes are due to be paid.
There are three types of insurance coverage which may be included in a mortgage payment. Like real estate taxes, insurance payments are made with each mortgage payment and held in escrow until the bill is due. The first type of insurance is property insurance, which protects the home and its contents from fire, theft, and other disasters. Flood insurance, a special form of property insur-ance, may also be required if the property is in a flood zone.
The third type of insurance is PMI (Private Mortgage Insurance) which is mandatory for homeown-ers who purchase a home with a down payment of less than 20% of the home’s cost. PMI protects the lender in the event the borrower is unable to repay the loan. PMI coverage may be dropped after a specific time or equity requirements are met. FHA loans require mortgage insurance for the life of the loan.
While principal, interest, taxes, and insurance comprise a typical monthly mortgage payment, some borrowers opt to not include taxes or insurance as part of the monthly payment. In this scenario, monthly payments are lower, but the borrowers must pay the taxes and insurance on their own.