In many areas, the real estate prices are higher than in 2008 and it has consequences – Nowadays, many young people have no other choice but to purchase their first home with a mortgage.
Mortgages are long-term loans that borrowers use to pay for the chosen property. Like any other loan, the monthly payment consists of two main components which a borrower should pay – principal and interest payment.
These loans are also known as secured because the lender has protected their money by collateral – the property in our case. In this article, readers will find out more information about mortgage payments.
Mortgage Main Components
Generally, a mortgage payment consists of two mandatory components – principal and interest, and two optional – taxes and insurance.
Let's take a look at each one of them and discuss them in detail.
The principal of a loan is the amount of money you actually borrow from the lender. If your mortgage is $100,000, then the principal is $100,000. This is one of the main components which comprises a loan payment. Keep in mind that, even though usually the monthly installment is fixed, the portions will change.
For example, at the beginning of the loan, the amount of money that goes to repay the principal is very low; mainly, the monthly payment consists of interest. As time goes by, the principal portion increases.
Since you use someone else's money, it is only logical that you pay them something in return; this is the so-called interest. The interest is determined by an interest rate which may vary significantly from 2-3% to over 10%. The higher the interest rate, the higher the monthly payment and the more your loan will cost.
Let's imagine we have two mortgage offers – one of them is $100,000 at 4.5% and the other one is $100,000 at 9%. Both loans have 25-year terms. As you can see the principal is the same, therefore the property you can purchase with this money will be the same. However, the difference is substantial when it comes to monthly payments. The first one is $444.67 and the second one will be $671.36. Not only will the monthly payment be higher but also the total cost of the loan.
Taxes cannot be avoided. If you become an owner, then you have to pay taxes on the property. Bear in mind that they vary significantly depending on various factors, such as the type of property, location, city, country, etc. Each country has the respective government body that regulates and collects taxes.
It's important to know that you can choose to include them as part of your monthly payment. Otherwise, you will pay your property taxes separately. If you decide to include them, the annual tax will be divided by 12 and then added to the monthly payment. Then, the lender will be responsible for paying your taxes when the time comes.
By insuring your property, you make certain that your home is protected from any damage or harm. There are two types of coverage: property insurance and private mortgage insurance (PMI). The former is responsible for all sorts of damages to your home, for instance fire, natural disasters, thefts, etc. Property insurance is not mandatory, however, most banks insist on their borrowers including it in their monthly payments.
PMI Is Mandatory
The PMI, on the other hand, is mandatory for all people whose down payment is worth less than 20% of the purchased real estate value. This is a safety measure and banks want to protect themselves should the owner of the property stop repaying their loan.
Usually, the PMI costs between $30 and $70 each month (if your loan is $100,000) and will be part of the mortgage payment. You can expect to stop paying mortgage insurance once your principal has reached 20% of the property's value.
How To Calculate a Mortgage Interest
As previously mentioned in the article, the monthly payment of your loan does not change (if this is an amortizing loan). However, the portions that comprise the payment will change over time. The rule is that in the beginning, the interest is much higher than the principal payment.
The interest payment changes because of the amount of money you owe changes. This is the reason why it actually goes down each month until the last payment when you pay off the balance. Therefore, to compute the interest you need the current balance.
Formula: current principal X annual interest rate/ 12 (months)
Steps to Compute The Interest
1. Check your current loan balance. You can find this information on your mortgage statement (you receive such each month).
2. As is written in the formula, the next step is to multiply the annual interest rate by the current loan balance. You can find the rate on your mortgage statement too. For instance, your loan is $100,000 at a 5% rate. The result is $5000.
3. Now, following the formula, we have to divide the annual interest by 12. In our case, $5000/12 is $416. As you can probably guess, this amount of money is the interest payment of the monthly installment.
4. Check how much is your overall monthly payment and subtract from it the monthly interest, in our case $416. The reason to do that is to determine how much of the principal you owe after each payment. Let's imagine that the monthly payment is $650. $650- $416= $234. The result shows that $234 will be the payment towards the principal.
5. Now that you know both the interest and principal payments, let's check on the balance. In step 2, we determined that the principal of the loan amounts to $100,000. Now, you have to subtract $234 (the principal payment) from $100,000 (principal). The result is $99,766. So, this will be the amount of money on which the interest will be estimated for the next month.