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How the Mortgage Formula Determines Your Monthly Payment

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Buying a house offers big financial benefits, but it’s a big financial undertaking. Before you buy, you’ll want to figure out just how much you’ll pay each month. That may be easier said than done unless you understand exactly how your mortgage payment is calculated. This article explains how lenders use a mortgage formula to figure out your exact mortgage payment. It also shows how you can use the same formula to set your own housing budget.

What goes into your monthly mortgage payment?

Most homebuyers have to account for three separate costs when they take out a mortgage. The costs include principal, interest, taxes, and insurance (aka PITI) and other payments to escrow.

Here are the three main components of your monthly mortgage payment.

#1 Principal and Interest

The biggest component of your monthly payment will be your principal and interest payment. Principal and interest payment covers the cost of the actual mortgage debt.

The principal value of your mortgage loan is the amount you borrow to pay for your house. Interest is the amount of money you pay to your lender for using their money. If you take out a fixed-rate mortgage, your principal and interest payment won’t change. Payments on adjustable-rate mortgages (ARM), may change up to once per year.

Whether you have a fixed-rate mortgage or an ARM, the amount of money going toward principal changes with each payment. Here’s how it works.

How much money goes toward interest?

With each mortgage payment, you pay interest first, then principal. The amount of money going towards interest equals your current principal balance multiplied by your annual interest rate divided by twelve.

As your outstanding loan balance decreases, the amount you pay in interest decreases, too. This is called amortization, which we’ll cover next.

How much money goes toward the mortgage principal?

When you take out a mortgage, the lender designs the loan in a way that allows you to pay off the principal value of the loan in a set period of time, usually 15 or 30 years.

However, the principal payoff doesn’t happen in even installments each month. At first, very little money goes toward the principal value. With your last few payments, most of the monthly payment goes toward principal payoff.

Why does it change? When you first take out a loan, you owe the bank a lot of money. You have to pay interest on every dollar you owe. As a result, your monthly payment is mostly interest with a little bit of principal. When you chip away at the principal balance, you owe less money to the bank. That means you have to pay interest on less money with each payment. With each payment, more money goes toward principal and less toward interest.

The amount that goes toward principal is determined by an amortization schedule. The amortization schedule shows the exact amount that goes toward your principal balance with each payment.

What if I pay extra?

If you make extra principal payments on your mortgage, you won’t reduce your monthly principal and interest payment. Instead, making extra payments reduces your principal balance. With each subsequent payment, you’ll have to pay interest on less borrowed money. That means more money goes toward principal reduction with each payment. Ultimately, you’ll pay off your mortgage sooner.

But be sure that your lender knows that you want that extra payment applied to your principal. This may be as simple as checking a box before you submit the payment online, or you may need to call your loan servicer/lender directly.

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#2 Mortgage insurance

In addition to your principal and interest payment, you may have to pay for mortgage insurance. This is most common when you put down less than 20% on the mortgage. Mortgage insurance protects lenders if you default on your mortgage. When considering homebuying, many people overlook the cost of mortgage insurance. Unfortunately, this can be a costly mistake. Mortgage insurance can add hundreds of dollars to your monthly mortgage costs.

Mortgage insurance requirements depend on the type of loan you take out (FHA, VA or conventional). The cost of mortgage insurance could also depend on your down payment amount, the size of your loan and your credit score.

Borrowers should compare different loan options to see which loan type gives them the lowest mortgage insurance costs.

#3 Other payments to escrow

In addition to paying your principal, interest and mortgage insurance payments, you’ll have to put money into an escrow account. The money you put into an escrow account it is used to pay for homeownership expenses that aren’t debt related. For example, your lender may escrow property taxes and homeowners insurance. Your lender will pay for these annual costs from your escrow account. Even if you didn’t have an escrow account, you would have to pay for these expenses.

What isn’t included in a monthly mortgage payment

A monthly mortgage payment isn’t your only housing cost. You may have to pay homeownership association (HOA) dues every month. You will also need to save some money for maintenance and repairs. These costs aren’t factored into your monthly mortgage payment, but they are important for you to consider.

Different formulas for different mortgages

One important thing to remember about the mortgage formula is that your actual monthly payment will depend on the type of loan you choose. Different types of mortgages require different types of mortgage insurance. Some mortgages have upfront mortgage fees, while others only require monthly mortgage insurance. These are a few of the differences between the most popular mortgage options.

VA loans. VA loans don’t require mortgage insurance. Instead, VA borrowers pay an upfront funding fee. Funding fees range in size from 1.25%-3.3% of the loan balance. Most borrowers finance the upfront funding fee which raises their monthly payment. The exact size funding fee varies based on your down payment amount, military status and whether you’ve used the VA loan before.

FHA loans. FHA borrowers have to account for two mortgage insurance costs in their loan formula. They’ll pay an upfront mortgage insurance premium of 1.75% of the principal loan balance. Most borrowers finance that fee. On top of that, FHA borrowers pay monthly mortgage insurance premiums (MIP) through the life of the loan, in most cases. Borrowers that put at least 10% down drop MIP after 11 years.

Mortgage insurance premiums (MIP) cost 0.8%-1.05% of the outstanding loan balance for 30-year loans.  MIP costs 0.45%-0.95% of their outstanding loan balance for 15-year loans.

Conventional loans. People taking out conventional mortgages only pay monthly private mortgage insurance (PMI) fees. Borrowers pay the PMI until their loan-to-value (LTV) ratio reaches 80%. LTV is the outstanding value of your loan divided by the appraised value of your house. Dropping mortgage insurance sounds appealing, but homebuyers need to plan to pay PMI for many years. Borrowers that put 3% down and pay a 4.5% interest rate will pay PMI for almost nine years.

Currently, PMI for 30 year fixed-rate mortgages costs range from 0.17%-1.86% of your loan balance. Your rate depends on your down payment and your credit score.

How to use a mortgage calculator

Instead of trying to do figure out all your costs by hand, use a mortgage calculator to help.

Check out LendingTree’s mortgage payment calculator here.

A mortgage calculator uses your personal information to calculate your monthly payment amount. It also breaks down the payment into principal and interest, mortgage insurance costs, and escrow costs. The final monthly payment amount gives you a clear idea of how much you’ll actually pay when you take out a new mortgage.

Many homebuyers will want to first look at the conventional mortgage payment calculator. This shows your total monthly payment based on the house price, your down payment and your credit score.

To make the calculator more accurate, you can enter information in “advanced options.” This is particularly helpful if you know your property tax rate, homeowners insurance costs, or you’ve been preapproved at a specific interest rate.

Service members who are eligible for a VA loan can use this calculator to show the costs of VA loan. Be sure to look at the “advanced options” to personalize the mortgage formula for your experience. Veterans who haven’t used the VA loan get a better deal on the upfront funding fee. Plus, disabled veterans may be eligible to have the fee waived.

Finally, buyers considering an FHA loan can use this calculator to understand their monthly costs.

Comparing payments from different calculators can help you decide which type of loan makes the most sense for you. In particular, buyers that cannot afford at least a 20% down payment should compare both a conventional loan and an FHA loan to see which makes the most sense.

What is your real housing budget?

Shopping for a new home can be a lot of fun, but the monthly costs of owning add up. Before you decide how much house you can afford, use a mortgage calculator to help you understand the costs of buying. When you consider every variable in the mortgage formula, you can buy a house that really fits your budget.


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