Mortgage insurance is a monthly pain in the budget. But it can make buying your first home possible. Here’s how it works.Full article
What’s in a mortgage payment?
October 5, 2017
When you buy a home, the most tangible and recurring cost you’ll encounter is your monthly mortgage payment. But many homebuyers don’t know what’s actually included in it. You might be thinking it's just about the loan itself, but there’s more to it than that. There are really four components, known as PITI (pronounced “pity”).
PITI: Principal. Interest. Taxes. Insurance.
As a homebuyer, you’ll want to have a handle on all four components and what they mean for your bottom line.
And here’s an important loan shopping tip: When you’re comparing mortgages from different lenders, make sure to compare apples to apples. The figures you’re looking at should be based on either PITI (all four components) or just principal and interest.
The principal is the amount you borrow from the lender. This is the sale price of the home minus your down payment. So if you buy a $200,000 house and put down $10,000 (5 percent), the principal is $190,000.
When you first buy a house, more of your monthly mortgage payment is going to interest than to principal, because you’re paying interest on such a large amount. As the principal goes down, so does the portion of your payment that’s going to interest.
Interest is what the lender charges for lending you the money to buy your home. Believe it or not, by the time you’re done paying off a 30-year fixed mortgage, it can be almost as much as the cost of the home itself. Ouch. Easing the pain somewhat is the fact that part of the interest is tax-deductible each year.
Again, let’s say you buy a $200,000 home with $10,000 down. You take out a 30-year loan for $190,000 at a fixed interest rate of 4.5 percent. At the end of 30 years, you will have paid more than $156,000 in interest! (We used Zillow’s amortization calculator to figure that out.) The sooner you pay down your balance, the less interest you’ll pay.
Are you beginning to see why homebuyers are so obsessed with interest rates? As you start doing the math on what you can afford, don't assume banks will give you the advertised interest rate. Yours could be higher, depending on several factors, including your credit score. A high score and a good overall credit history will earn you a better rate.
Taxes are 1/12 of the annual property taxes on your home. Some homeowners pay their property taxes directly, but lenders usually estimate the amount and fold them into your monthly mortgage payment, and then the loan servicer handles it all. That way, the lender can be certain that the taxes get paid.
How does this work? The portion of your taxes that you pay each month is held in escrow until the tax bill comes due, and then the servicer pays it for you. (When something is placed in escrow, it simply means that it’s placed with a third party, a middleman.) Since the amount is an estimate, sometimes there’s an adjustment at the end of the year, and you get a little back or owe a little extra.
By the way, a lot of first-time homebuyers don’t realize just how much homeowners pay in local property taxes — nationally, an average of more than $2,000 each year. Property tax rates can range all over the place, so this is another thing to research and account for when deciding how much house you can afford, and where.
Insurance protects both you and the lender. It might include both homeowners insurance and private mortgage insurance (PMI), or mortgage insurance premium (MIP) if you have an FHA loan. As with property taxes, these costs are often paid as part of the monthly mortgage payment.
This of course protects you from loss and liability. You could have a fire, or your maple tree could fall on your neighbor’s garage. You wouldn’t want to go without insurance, but in any case, you can’t get a mortgage loan without it, because the lender needs to know that their investment is protected. So, as with property taxes, you often pay toward your annual insurance bill each month as part of your mortgage payment, and it goes into escrow. Homeowners insurance can run between $300 and $1,000 a year, on average.
PMI: private mortgage insurance
This protects the lender if you can’t repay your mortgage. Most conventional loans require PMI if your down payment is less than 20 percent, which you won’t be surprised to hear is the case for most people. The cost depends on several factors, but it’s usually about 1 percent of the loan amount annually. Going back to the $190,000 loan example again:
$190,000 x .01 = $1,900 in annual PMI
$1,900 ÷ 12 = about $158 in monthly PMI
Yes, $158 a month. As you can see, PMI is something you need to consider when deciding how much house you can afford. It’s an extra burden, and yet it makes it possible for you buy a home if you can’t put 20 percent down. Once you’ve paid off enough of the loan, you can get rid of PMI.
MIP: mortgage insurance premium
A similar insurance, known as MIP, is required for some government-backed loans, such as FHA loans. These loans have low down payment requirements, so they’re popular with first-time homebuyers. MIP has two parts:
- An upfront premium of 1.75 percent of the loan that can be financed as part of the loan.
- An annual premium that, like PMI, is spread over 12 payments. The annual rate varies with your down payment. If your down payment is less than 5 percent, it’s .85 percent of the loan amount.
READ NEXT: Wondering how much house you can afford? PITI is part of your answer, but if you’re ready to get more specific, we’ve got it down to just six steps. All you have to do is gather a few numbers and plug them into our favorite calculator.
Ready to take the next step in your homebuying journey with all the confidence of a smart and savvy homebuyer? Our comprehensive online homebuyer course is simple and easy to access on your computer, tablet, and mobile device. It's all the information you need, all in one place. Go ahead and get started today.