What makes up a mortgage payment? [learn the components]

If you are in the process of buying your home or thinking about homeownership, at some point you will need to apply for a mortgage loan. This is a big step, so you want to ensure the mortgage payment will be affordable. To do that, it is helpful to understand what components make up a mortgage payment.

There are four main components: principal, interest, taxes and insurance (PITI). In this blog, I will discuss each of these in depth, using a $200,000 mortgage as an example.

The four main components that make up your mortgage payment:

1) Principal

This is the amount of money you borrowed to purchase your home. If the price of your new home was $250,000 and you put down a 20% down payment ($50,000), you would need to take out a loan for the remaining 80% or $200,000.

Like many loans, when you start making monthly mortgage payments, the amount of the payment that goes towards principal is quite low; most of it will go to pay the interest on the loan. As you continue to make payments over the term of the loan, more of your monthly payment will go toward the remaining principal and less toward interest.

2) Interest

Interest is the fee you pay to the lender for the amount of money borrowed; it is calculated as a percentage of the loan. The lender sets the interest rate and considers many factors when setting it; the main factor is your credit score. The higher your credit score, the lower your interest rate is likely to be because you are seen as a lower risk for defaulting on the loan. Conversely, if your credit score is low, the interest rate will be higher since you will be perceived as a higher risk. It is a good idea to “shop around” for the best rate before settling on a mortgage lender.

The type of mortgage product you choose is another important factor in determining your interest rate. If you have a conventional or Federal Home Administration (FHA) loan, which is government insured, the mortgage will likely have a fixed rate, meaning your interest rate will stay the same throughout the life of the loan. In contrast, an adjustable rate mortgage (ARM) has interest rates that fluctuate heavily with market conditions. Most interest rates for ARMs are fixed for a few years before the loan changes to a variable interest rate for the remainder of the term. For example, a 5/1 ARM is a mortgage that has a fixed interest rate for the first five years, then the interest will adjust annually thereafter.

Going back to $200,000 mortgage example, let’s say you got a 30-year fixed conventional loan at a 6% interest rate. The first monthly principal and interest payment would be $1,139.

3) Taxes

Local governments assess taxes on your home and use them to fund public services like public schools, police and fire protection, and libraries. Your property tax bill is based primarily on two factors:  the assessed value of your home and local tax rates.

Property taxes are calculated on an annual basis. Unlike principal and interest, they are not always factored into your monthly mortgage payment. If they aren’t, in most cases you will be billed biannually and can make payments through your local county’s website.

When property taxes are included in a mortgage payment, the lender divides the total amount of taxes due by 12 and adds this figure to the total payment. When you pay the mortgage, the lender puts the monthly amount for taxes into an escrow account and holds them until the taxes are due. Nowadays, most lenders require an escrow account, which is usually an easier way to manage property tax payments compared to a large lump sum payment once per year.

Back to the example of the $200,000 mortgage, let’s say the annual property taxes are $2,976. Broken down by month, this would come out to an additional $248 per month, which would go into an escrow account. 

4) Homeowner’s insurance

Lenders require homeowner’s insurance with a mortgage. This is beneficial to both you and the lender, as it protects the investment in the event of a disaster (e.g., fire or flood). It is also possible to get coverage for protection from a liability (e.g., a guest is injured in your home) as well as protect against damage to personal property (e.g., furniture or appliances).

Just like property taxes, homeowner’s insurance premiums can be paid separately from the mortgage payment (e.g., bundled with auto insurance), or the lender can divide them up into monthly amounts and place them in an escrow account.

Now back to the $200,000 mortgage. Let’s say you found an insurance policy that completely covers everything mentioned above and you are quoted a six-month premium of $2,976. This adds roughly $496 each month and makes your total monthly payment $1,883 (principal, interest and property taxes included).

Additional costs that could impact your mortgage payment:

** Private mortgage insurance (PMI)

If you do not have enough money to make a 20% down payment on your home, the lender will require private mortgage insurance (PMI). Just like having a lower credit score (i.e., less than 700), having a down payment that’s less than 20% makes a borrower a higher risk when lending. Therefore, PMI is meant as extra protection to the lender’s investment and does NOT cover anything in the home.

Let’s say you were only able to come up with a down payment of 10% on a $200,000 mortgage ($20,000), and your private mortgage insurance premium is $92 a month. The size of the down payment will increase your monthly payment because the ratio of the loan to the value of the mortgage increased. However, once you have paid 22% of your mortgage balance, your lender is required, under the Homeowner’s Protection Act of 1988, to automatically cancel this insurance premium — as long as you have stayed current on your payments.

** Homeowner’s Association Fee (HOA)

If you’ve purchased a condominium or a townhome, there is typically a homeowner’s association fee each month. This fee helps pay the association’s costs for property maintenance and improvements. In some communities, the HOA fee might also cover utilities such as water/sewer or trash/recycling.

While the association fee is NOT included as part of the official mortgage payment, you should still factor it into your budget to make sure the overall monthly housing amount is something you can afford.

Where to get assistance and support

To assist you in calculating your estimated monthly mortgage payment, there are online tools to help. For example, this NerdWallet calculator not only computes your payment but also has a special tab that shows how much you’re paying towards principal and interest over time.

Plus, our HUD-certified homeownership counselors can work with you to determine how to fit your mortgage payment into your budget and answer other questions you have about the homebuying process. Learn more about our homeownership counseling services, and call 888.577.2227 to set up a free and confidential appointment.

Author Ray McCoy is a certified financial counselor with LSS Financial Counseling.