Understand Your Mortgage Loan Payments Amortization Structure

(January 21st, 2008)

Understanding your mortgage payment structure helps you pay off your home faster, and save more money in interest costs over the life of the loan. Almost anyone who owns a home has a mortgage to pay off. Latest mortgage rates are published on every newspaper and on TV. This may make it seem like mortgages have always been available, since man was born. But this it not the case! The modern art of mortgage loan financing was pioneered in 1934 by the US Federal government that wanted to wear off the effects of the Great Depression of 1934. They did this by minimizing the required down payment on home purchases. Before 1934, you couldn't get a home unless you had 50% of the purchase price in your bank. This was reduced to 20% in 1934, and nowadays, you could get away with 10%! The aim of this article is to teach you how to set up your payment structure so as to be able to pay off your loan as fast as your income allows it, as well as save money on interest costs.

There are 2 primary factors that determine your monthly mortgage loan payment. One is the size of the loan (the total loan amount you borrow) and the second is the length of amortization of the loan. This can range from 15 years, 25 years or even 30 years. It is interesting to note that there is an inverse relationship between the size and length of the loan. The greater the length of the loan, the less the monthly payments will be. This why 30 year mortgages are becoming very popular in America.

PITI - The 4 Components of a Mortgage Loan

Once you have determined the size of the mortgage loan as well as the length of the amortization term, there are 4 factors that will determine your monthly mortgage payment. These factors are Principal, Interest, Taxes and Insurance. Assume you borrow a $200,000 mortgage loan; we will analyze those 4 factors using this amount.

i) Principal - A portion of your monthly payment is dedicated towards the original principal loan, in this case being $200,000. Mortgage loans are structured in such a way that in the first few years of the life of the loan, most of your monthly payment will go towards interest, and little towards the principal. As you pay down the principal over 2-3 years, more of your payment will then be applied towards the principal, and less towards interest. This is why we say it is essential to have a 20% down payment in cash, so as to minimize the interest costs you will pay.

ii) Interest - Interest is the reward that the lender gets by risking his money to you and allow you to purchase the home. The interest rate on the mortgage has a direct impact on monthly payments; higher interest rate means a higher monthly payment. For example, the total monthly payment on a $200,000, 30 year mortgage loan with 5.5% interest is calculated as follows:

We derived these numbers using our Mortgage Loan Amortization Schedule Calculator. View more useful and sophisticated mortgage calculators.

iii) Taxes - Annual property taxes are set as a percentage by the government every year and can be paid as one lump sum payment, or as part of your monthly payments. If you make payments to your lender, your lender will hold your tax obligations in an escrow account, and remit to the government at year end.

iv) Insurance - Just like property taxes, property insurance is payable monthly and is accumulated in an escrow, and remitted to the insurance agency at year end. Property insurance protects the house from theft, fires, and other disasters. The other type of insurance is Private Mortgage Insurance (PMI). Borrowers have to pay PMI if their down payment is less than 20% of the purchase price of the home. This PMI protects the lender from your defaults and if you go in to foreclosure.

Mortgage Amortization Schedules

To get a detailed amortization schedule, use Mortgage Loan Amortization Schedule Calculator. If we use the example below of a $200,000 mortgage loan with 5.5% interest rate amortized over a 30 year period, here is the breakdown of monthly payments going towards principal, interest and the owing balance.

Notice how in the first year (Payment 1), a whopping $916.67 from your total payment was applied to interest. You would think this is unfair or really messed up, but that's how a mortgage loan is structured. Notice though that in Year 30 (Payment 360), almost your entire payment of $1130.40 is applied towards your principal balance owing; only $5.18 goes to interest. Now you think it's a good deal??