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With a mortgage loan, you'll typically make just one monthly payment. However, that payment is often broken down into four components: principal, interest, taxes and insurance (PITI).
Understanding how those four costs break down can help you understand the cost of borrowing to buy a house, and it may also give you some opportunities to save some money.
1. Principal
A loan's principal is the amount you owe. When you close on a mortgage loan, the lender amortizes the loan, ensuring that your monthly payments of principal and interest will result in a zero balance at the end of your repayment term.
At the beginning of your loan term, only a small portion of your monthly payment will go toward paying down the principal balance. As your balance decreases over time, however, the principal portion of your payment will grow.
For example, let's say you close on a $400,000 loan with a 6% fixed interest rate and a 30-year repayment term in August 2023. Your monthly payment of principal and interest will be $2,398.20.
During the first month, you'll multiply $400,000 by 0.005—the annualized interest rate of 6% divided by 12—to get $2,000 in interest. The remaining $398.20 will pay down the principal. During the second month, the monthly interest rate is applied to a balance of $399,601.80, resulting in $1,998.01 in accrued interest.
In February 2042, more than 18 years into your loan, roughly half of your payment will go toward interest and the other half toward principal. After that, the majority of your payment will pay down the loan balance.
2. Interest
Interest is one of the costs of borrowing money. As shown in the example above, mortgage interest accrues each month based on the loan's interest rate and current balance.
That said, the interest component of your mortgage payment can become more complex if you opt for an adjustable rate instead of a fixed rate. With an adjustable-rate mortgage, you'll typically have an initial period of three to 10 years, during which your rate is fixed. After that, though, the rate can change every six or 12 months based on a benchmark market rate and the terms of your loan.
In other words, your loan payments will move up or down with each adjustment to account for the new rate and to ensure that you stay on track to pay off the loan by the end of the repayment term.
Refinancing your loan can potentially help you reduce your interest rate or switch from an adjustable rate to a fixed one, which could save you money and reduce your payment amount.
3. Taxes
Regardless of where you live in the U.S., you'll be required to pay property taxes on your home. While it's possible in certain cases to pay the bill directly to your local government each year, a mortgage lender will typically estimate your annual tax liability, break it down into monthly installments and include it in your mortgage payment.
The tax portion of your monthly payment will go into an escrow account, a savings account managed by your lender. Once your bill comes due, the lender will pay it on your behalf.
If the lender overestimated your property tax bill, you may receive an escrow refund. The lender may also reduce your monthly payment for the upcoming year. On the flip side, if your escrow balance isn't enough to cover the bill, you may have the choice to pay off the escrow deficiency in full or agree to a higher monthly payment for the next year.
Even if you pay the deficiency in one lump sum, the lender may still increase your payment to ensure full payment of the following year's tax bill. This can also happen if your local tax rate or the assessed value of your property increases.
4. Insurance
The final element of a mortgage payment is insurance. Since you've financed the purchase of your home, your lender will typically require homeowners insurance, which can protect you against damage, theft and other losses due to certain events. You may be able to reduce your homeowners insurance premiums by shopping around every year or two.
Additionally, you may be required to pay mortgage insurance, which protects the lender in the event that you default on your loan. If it's a conventional loan, you may be required to pay private mortgage insurance (PMI) if you put down less than 20% on the purchase, though you can have PMI removed once you pay down your loan balance to roughly 80% of the home's value.
Some government-backed loans also require mortgage insurance, though it's not always possible to get it removed.
Payments for insurance also typically go into your loan's escrow account, and they can change over time as the cost of insurance goes up or down.
The Bottom Line
Mortgage payments typically have several moving parts, so it's possible for the amount you owe each month to change over time, even if you have a fixed interest rate. As you look at the different components of your monthly payment, consider potential ways you can reduce how much you owe.
Potential options include refinancing your loan at a lower interest rate or switching to a fixed rate instead of an adjustable one, shopping around for homeowners insurance to see if you can get a lower premium or talking to your lender about your options for removing mortgage insurance.
Remember, building good credit is one of the best ways to save money on a mortgage loan—and any other debt, for that matter. Monitor your credit regularly, pinpoint areas you can improve and develop good credit habits to build and maintain a strong credit history.