What is a mortgage?
A mortgage is a long-term loan that a borrower obtains from a bank, thrift, independent mortgage broker, online lender or even the property seller. The house and the land it sits on serve as collateral for the loan. The borrower signs documents at closing time giving the lender a lien against the property. If that borrower doesn't make payments as agreed, the lender can take the home through foreclosure.
Pay out over time
Because mortgages are such large loans, consumers pay them off over long periods -- usually 15 to 30 years. Their monthly payments gradually whittle away the principal balance.
A monthly mortgage payment is sometimes called a PITI payment. That's because each one covers a portion of the following four costs:
Principal -- the loan balance
Interest -- interest owed on that balance
Real estate taxes -- taxes assessed by different government agencies to pay for school construction, fire department service, etc.
Property insurance -- insurance coverage against theft, fire, hurricanes and other disasters
Borrowers can choose to pay their real estate taxes and insurance in lump sums when they come due, rather than in monthly installments to their escrow accounts. Depending on the kind of mortgage a borrower has, the monthly payment may also include a separate levy for private mortgage insurance (PMI) or government-backed mortgage insurance premiums.
The breakdown of each payment (the amount that goes toward principal, interest, etc.) changes over time because mortgages are based on a repayment formula called amortization. That's a fancy term meaning the lender spreads the interest you owe on the mortgage over hundreds of payments so that the overall loan is as affordable as possible.
How does amortization work?
On a 30-year, $150,000 mortgage with a fixed interest rate of 7.5 percent, a homeowner who keeps the loan for the full term will pay $227,575.83 in interest. The lender can't possibly expect that person to pay all that interest in just a couple of years, so the interest is spread over the full 30-year term. That keeps the monthly payment at $1,048.82.
But the only way to keep the payments stable is to have the majority of each month's payment go toward interest during the early years of the loan. Of the first month's payment, for instance, only $111.32 goes toward principal. The other $937.50 goes toward interest. That ratio gradually improves over time, and by the second-to-last payment, when we're all driving hovercars and have colonized the moon, $1,035.83 of the borrower's payment will apply to principal while just $12.99 will go toward interest.
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