A monthly mortgage payment includes at least two parts: an amount that goes toward the principal of the loan (the money you've borrowed) and a second amount that goes toward interest (the cost of borrowing the money).
For most homeowners, however, there is also a third part of the mortgage payment: an amount that is paid into an escrow account that the lender maintains for you to pay for things like homeowners hazard insurance, property taxes, condominium and association fees and mortgage insurance (if applicable). This is the element of the monthly payment that can go up or down even in a fixed-rate mortgage.
Together, these elements are called PITI:
- P — Principal
- I — Interest
- T — Taxes
- I — Insurance
Homeowners must pay property taxes and they must have some type of homeowners insurance. Depending on state laws and other variables, most lenders require homeowners to pay into what is called an "escrow account." In this account, the lender or mortgage servicer keeps enough money to cover your property taxes and homeowners insurance. You pay into this account each month as part of your mortgage payment. When your taxes are due, the lender/servicer pays them for you. The same is true for your insurance.
The lender/servicer sends you a periodic statement showing how much is in this account. You can compare the statement with your property tax bill and your homeowners policy to ensure that the right amount is being held to cover the payments. The Real Estate Settlement Procedures Act (RESPA), which is enforced by the U.S. Department of Housing and Urban Development (HUD), is the major law covering escrow accounts.
It is important to maintain the required property insurance on your home. If you don't, your lender/servicer can buy insurance on your behalf. This type of policy is known as "force placed insurance"; it usually is more expensive than typical insurance, and it provides less coverage.
If you're buying a house, most sellers disclose the amount of the annual property taxes on the house when it is listed for sale. If they don't, you can easily get this information from your local property tax assessor. A local insurance agent can give you an idea of the annual insurance cost. Divide each of these numbers by 12 and add them to the principal and interest to get the estimated total monthly payment.
If a buyer puts down less than 20 percent of the selling price on the mortgage, lenders may require the buyer to buy another type of insurance called private mortgage insurance (PMI). This provides insurance to the lender in case the buyer is not able to repay the loan and the lender is not able to recover costs after foreclosing the loan and selling the property.
The annual cost of PMI can vary but usually is between .19 percent and 1 percent of the total loan value, depending on the loan terms and loan type. PMI can be paid up front but most buyers prefer that it be included in their mortgage payment. The cost can vary based on several factors that include: loan amount, loan-to-value ratio, occupancy (primary home, second home, investment property), documentation provided at loan origination, and probably most of all credit score.
Once the principal of the loan reaches 80 percent (the owner has 20 percent equity in the home), the PMI is usually no longer required and can be canceled, although you may have to prove your equity by having a new appraisal done to show that the house is worth at least 20 percent more than you owe on it. (Note: Some lenders may require that PMI be paid for a fixed period even if the principal reaches 80 percent.) The cancellation request must come from the servicer (the company you send your mortgage payment to) of the mortgage to the PMI company that issued the insurance.
Note: PMI may be waived or avoided through some types of government or other loans. Check with your lender to determine your situation.
Maria and George have found a home that costs $150,000. They are able to make a downpayment of 5 percent, or $7,500. The annual property taxes are $1,650 and the annual homeowners insurance is $780. These payments are made in monthly installments in their mortgage and are held in an escrow account. When their taxes and insurance are due, the lender (or mortgage servicer) makes the payments for them.
Because their downpayment is less than 20 percent, Maria and George will pay PMI as part of the mortgage payment. With a 30-year fixed mortgage and an interest rate of 6 percent, the PITI with PMI is as follows:
- Principal and Interest (P and I): $854.36
- Monthly Property Taxes (T): $137.50
- Monthly Property Insurance (I): $65.00
- Private Mortgage Insurance (PMI): $85.50
- Total payment: $1,142.36
Paying half your mortgage every two weeks instead of a full payment once a month can be done with most any type of loan but is most common with a 30-year fixed-rate loan. Doing so pays your mortgage more quickly because you pay the equivalent of 13 months of payments each year. For people who can budget to make a half-payment every two weeks, this offers more rapid building of equity. You can choose to do this on your own. Many people have it automatically deducted from their checking accounts.
Because your payments are applied to the loan every 14 days, the principal amount decreases faster, saving you more in interest costs. Your loan term shortens to 22 or 23 years, providing a substantial decrease in total interest costs. For example:
Monthly mortgage payment (12 months/12 payments): $997
Interest paid over the life of the loan: $209,263
Paid off in 30 years
Half payment (13 months/26 payments): $498 ($997 / 2)
Interest paid over the life of the loan: $155,938
Paid off in 22-23 years
Interest savings over the life of the loan are $53,325 – paid off in 22-23 years instead of 30 years!
Another option — if you can afford a slightly higher monthly payment — is to achieve the same savings with monthly payments. To do this, you would need to pay an extra amount of principal to your total mortgage each month. Using the above example, with a mortgage payment of $997, you would add $83 a month ($997 divided by 12) toward the principal (You will need to specify the extra amount for "principal only" on your payment.), making your payment $1,080. The interest savings would be the same and the loan would be paid off about seven years early, but you wouldn’t have to commit to making payments every two weeks.