Principal vs. Interest | Loan Terms Explained
In trying to understand your mortgage payment, it’s important to consider the principal and interest. Having a good concept of what both of these terms entail will help you determine the best mortgage option for your needs. If you can’t figure out what kind of mortgage payment you’ll be responsible for, it will be nearly impossible to make the right decision. That’s where we come in. We’re going to break down what these items mean to you and how they affect the bottom line.
What is Principal?
This is the amount of money that you borrowed on your home. To determine what your principal is, simply find your home’s sale price and subtract the amount of your down payment. So, if you bought your home for $100,000 and put down $10,000 (or 10% down), you would still owe $90,000. This is covered by your mortgage lender when you take out a mortgage, meaning you owe your mortgage lender $90,000. Thus, the principal balance of your mortgage is $90,000. Of course, there is interest involved here, too. This is how lenders make money, so you’ll have to factor that into the final equation when determining what you’ll owe in the end. In addition, you’re going to have to factor in any maintenance, insurance, taxes, repairs, and so on. You are responsible for all of these things and they can greatly impact your budget. It is therefore crucial that you consider all possible expenses before agreeing to a mortgage amount. To help you with this, we recommend using a free online mortgage calculator . You can quickly and easily calculate a breakdown of your loan so you can make an educated decision on what you can afford. Mortgage calculators like the one linked above include fields for the following:
- Buying or Refinancing
- Home Insurance
- Down Payment
- Monthly HOA
- Loan Amount
- Interest Rate
- Property Tax
- Home Value
- Loan Term
- Loan Type
- Start Date
- PMI
A repayment summary is displayed after calculating your fields so that you’ll know where you stand in the amount that you can afford.
What is Interest?
Now that you understand what the principal consists of, let’s examine the interest. This is the second part of your mortgage payment. Your mortgage payment wouldn’t be complete without interest – or at least, it would be wholly inaccurate. As we mentioned a moment ago, interest is how your mortgage lender makes a living. In exchange for giving you a loan, you pay your lender additional costs on the amount of the loan. Most lenders determine what your interest payments will be by calculating the loan’s APR (Annual Percentage Rate). As its name suggests, APR is the interest that you pay each year. Let’s assume for a moment that you borrowed $50,000 and that your loan has an APR of 5%. At that rate, you would pay $2,500 in interest each year. Your principal is going to be higher at the start of your loan. As such, you can expect the majority of your monthly payment going toward whittling down the interest. Your loan’s Annual Percentage Rate makes all the difference in what you’ll be paying. Furthermore, determining your APR depends on several factors. Your mortgage lender is going to take into account your credit score, what kind of income you bring in, and the amount of your down payment. They are also going to consider where your home is located, as this can affect your APR, as well. If you aren’t happy with the APR presented to you, don’t despair. There are things you can do to improve it, namely, working on your credit score. It never hurts to compare lenders, either. You may find that you can get a much better rate by going through a different party. As we stated, your APR is critical, and the smallest variation can equal out to big sums of money in the end. Just two percentage points can amount to tens of thousands of dollars by the time you pay off your loan, especially on a standard 30-year loan. As such, you must take the time to speak with different lenders to see what your options are.
Additional Expenses
Your monthly payment consists mainly of principal and interest. However, there are other items to consider depending on which lender you go with. Some loans only require you to pay the interest and principal, while others tack on additional expenses. Let’s take a moment to discuss these potential fees so you know what to expect when comparing loans and lenders. Having an understanding of what your potential payment entails will make it easier to converse with your lender and agree on a payment arrangement that you can afford. Taxes It doesn’t matter where you live, property taxes are a mandatory part of owning a home. These taxes can be mighty expensive, as they are what help keep schools and fire departments in operation, just to name a few. How much your taxes equal out to largely depend on your home’s value. Other factors that can affect your property taxes include things around your home, such as local amenities. This is one of the reasons you are required to have your home appraised. It helps the government determine what your taxes should come to. What’s more, you may need to get your home appraised every so often. This is because taxes are subject to change every year. When an appraisal is performed on your home, an assessor values your property based on the current market of your local real estate and comes up with the appropriate taxes. Insurance While it isn’t a law that you must have homeowners insurance, mortgage lenders won’t loan you money unless you have it. This is understandable, as anything can happen to your home over the course of your loan term. Anything from break-ins, fires, storms, and more can affect the value of your home. With insurance, your mortgage lender has the peace of mind that your home is sufficiently protected from such damages. Thus, your lender doesn’t lose out on their investment if something happens to your home. If you live in an area that is susceptible to flood damage, your mortgage lender may require you to get another policy that protects you from such things. And if you have something of particular value in your home that needs financial protection, you may need to buy a rider policy. This is simply an additional clause that can be added to your existing homeowner's insurance. Many homeowners will invest in this clause if they have a valuable piece of art or jewelry, for example. While it’s true that homeowners insurance protects you in the event of a break-in, you’re only covered to a certain degree. If your valuable artwork is stolen, basic homeowners insurance likely wouldn’t be able to cover the costs. A rider clause will. In fact, it extends your financial protection to cover the total value of your rider item. Determining the cost of homeowners insurance depends on a few key factors, such as your home’s proximity to police, fire, and rescue. The value and age of your home are also considered, as is its location. Lastly, insurance companies will consider if you live in a rural or urban area. There are some additional factors that can increase your insurance rates, such as owning a swimming pool. As with mortgage lenders, you should be sure to compare rates among several insurance providers to ensure that you get the best one for your budget. Escrow Your mortgage lender could take out an additional percentage of your monthly payments so that it can be placed into your escrow account. These are the monies you owe toward property taxes and homeowners insurance. The money is put aside into the escrow account to ensure your mortgage lender that these vital bills are paid on time. The nice part about this is that your mortgage lender will pay these bills on your behalf. How much escrow gets deducted from your monthly payments largely depends on what your current insurance rates are and the total of your property taxes. It’s possible for these rates to change. As such, your mortgage lender may re-evaluate the amount they take from your monthly payments to be put into escrow.
Summary
Understanding your mortgage and all of the fine print therein will give you an advantage as you compare lenders. We recommend that you revisit this page prior to speaking with each lender so that you are well-prepared. We also invite you to explore our other helpful articles for information on home loans, real estate, starting your own business , and much more. Our Seek Capital experts have compiled a wide variety of resources to assist you in your ventures, so be sure to check back frequently for the latest updates. Sources https://www.mortgagecalculator.org/ https://www.consumerfinance.gov/ask-cfpb/what-is-private-mortgage-insurance-en-122/ https://www.creditkarma.com/advice/i/what-is-apr