First-time homebuyers might get quite the shock looking at their first mortgage statements—especially when they see how much they’re paying toward interest and how little they’re paying off the principal. Here's a mortgage payment breakdown, showing what mortgage payments include, and why interest is such a big component of each month’s payment.
The principal is the amount that you borrowed in your mortgage loan. Any extra payments in a given month can be applied to the principal to reduce the length of the loan and the overall accrued interest (assuming your lender lets you make extra principal payments without a prepayment penalty). Typically, more money will go toward interest than the principal at first. According to FortuneBuilders, banks use this method to protect their investments against the possibility of a default.
Each monthly payment also helps pay off the interest, the interest being the source of profit for lenders. Higher interest rates make for higher monthly payments, as the interest is the product of the interest rate—which is either fixed or adjustable, depending on the loan—times the outstanding principal balance.
Lenders will offer amortization schedules that show the breakdown of each monthly payment, so borrowers can see how much of each payment will go to the principal and how much will go to interest. Additionally, online calculators such as NerdWallet’s show how mortgage payments can change year by year. In a 30-year mortgage of $100,000 with a 4 percent interest rate, for example, your monthly mortgage payments will primarily go toward interest until the 14th year.
Nerdwallet also shows the difference between a 15-year mortgage and a 30-year mortgage. With a 30-year mortgage loan of $400,000 at 3.5 percent, one would pay $1,796.18 each month and a total of $646,624 by the end, after interest. With a 15-year mortgage of the same amount at the same interest rate, one would pay $2,859.53 each month but only a total of $514,715 by the end.
Some of your monthly payment also goes into an escrow account if you’ve set one up. That way, you can pay for yearly homeowners' insurance premiums on a monthly basis, and the bank would automatically pay the premium each year.
Another type of insurance that might be included in a mortgage payment is PMI (private mortgage insurance), which is applied when the homebuyer’s downpayment is than 20 percent of the cost of the home. However, PMI coverage can be dropped once the buyer establishes 20 percent equity in the home. “This type of insurance protects the lender in the event the borrower is unable to repay the loan,” Investopedia explains. “Because it minimizes the default risk on the loan, PMI also enables lenders to sell the loan to investors, who in turn can have some assurance that their debt investment will be paid back to them.”
The same escrow account, if you have it set it up as such, also collects money for property tax until each due date and then automatically pays the bill. That’s a good thing, FortuneBuilders points out, because if you default on your property tax, you could face foreclosure. Any leftover escrow at the end of the year, meanwhile, will either be refunded or rolled over to the next year.