Once you know the costs that go into a monthly payment and how they're calculated, you can set a comfortable budget for your total finances as a homeowner.
What's in a monthly payment?
A typical monthly payment is made up of principal and interest, and may also include taxes and insurance.
Principal is the amount of money you've borrowed or your outstanding loan balance. You pay a portion of the principal with each mortgage payment.
Interest is the amount you're charged for borrowing money and is paid directly to your mortgage servicer.
Property taxes are paid to your local government based on your home's assessed value. They may be part of your monthly payment if you have an escrow account, or paid directly to the assessor's office.
Homeowners insurance protects you against damage to your home caused by fire, theft, wind and/or other covered causes or events. A lender usually requires the insurance coverage amount to equal the property value. If you live in an area that's prone to natural disasters, like earthquakes and floods, you'll need additional policies to cover the risk. As with property taxes, homeowners insurance is paid either directly to your insurance company or as part of your monthly mortgage payment through an escrow account.
Mortgage insurance (often referred to as MI or PMI) covers lenders against nonpayment or default on a mortgage. It's usually required when the loan amount is larger than 80% of the appraised home value.
What is an escrow account?
An escrow account lets you pay toward your annual tax and insurance costs each month. The money you pay is deposited into an account managed by your mortgage servicer, who makes the payments for you when tax and insurance bills are due.
Mortgage loan amortization is the gradual repayment of your loan principal as you make monthly payments.
The amortization period is the amount of time it will take for you to pay off your mortgage. The longer it takes to pay off a loan, the more interest charged. Your monthly payment's interest portion is based on the scheduled amount that you owe each month.
For a fixed-rate mortgage, the monthly payment stays the same but the portion that goes toward principal increases over time. The payment's interest portion is based on the scheduled amount that you owe each month.
An amortization schedule shows a breakdown of your monthly payment into principal and interest components.
Sample amortization schedule
Loan Amount: $100,000 | Term of the Loan: 30 years | Interest Rate: 6%
Monthly loan payments: $599.55 Total interest paid over the life of the loan: $115,838.19
For this example, starting with payment number 223 (18 ½ years into the loan), the principal amount is larger than the interest. By the time the last payment is due, the interest is only $2.98 compared to the last principal payment of $596.57.
Generally, most lenders will not offer a term over 30 years.
Benefits of early repayment
Making extra monthly payments to pay off your mortgage early can reduce the amount of interest charged throughout your loan.
Setting up your own payment plan
Making extra mortgage payments, above and beyond your minimum monthly payment, is an effective way to pay off your mortgage sooner. Setting up a payment plan gives you the flexibility to make the extra payments when you have the money available. Just keep in mind that you would need to specify with your lender whether you want the extra payments to be applied to your principal, or to future monthly mortgage payments.
If you pay off all or part of your mortgage earlier than agreed, some lenders will require you to pay an early repayment charge.