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When you pay your mortgage, the money doesn’t necessarily all just go to one place. Read on to learn where it ends up.
After you buy a house, you’ll likely begin writing a monthly check to your mortgage lender (unless you paid cash for the property).
When you pay your mortgage, though, the money you’re sending in doesn’t just go to one place. There are different uses for the funds you’re sending out of your bank account.
So, where exactly is your monthly mortgage payment going? Here are three potential places the funds could end up.
Principal
Your monthly payment goes toward paying down the principal balance on your mortgage loan. This is the best use of these funds for your interests, because as you pay down the principal, you gain equity in your home.
Unfortunately, when you first start paying your mortgage, very little of each payment goes toward the principal since most of the interest you owe is front-loaded (you pay a lot more interest upfront than later on since you’re paying it on a larger balance).
Say, for example, if you borrow $200,000 over 30 years on a mortgage loan at 7%. You’d have a monthly principal and interest payment of $1,330.60. The table below shows how much of that payment would go to principal versus interest at different times in your loan.
As you can see, it would take you until your 242nd payment before more of your monthly payment ends up going toward the principal in this loan scenario. Eventually, though, you will pay down your entire principal balance and will be left owing $0.
Interest
As the table above shows, most of your monthly mortgage payment is going to go toward interest for a very long time. Interest is the amount you pay to borrow. The higher your rate, the higher your monthly payment and total borrowing costs will be.
Over time, you’ll usually pay more in interest than it costs you to buy the house in the first place. For example, with our $200,000 loan at 7% over 30 years that we used as an example above, you’d end up paying a total of $279,017.80 in interest over the life of the loan.
The good news is, you can try to reduce the interest costs you owe by aiming to qualify for the best mortgage rate possible. To do that:
Shop around among different lenders. Get quotes from several lenders, including banks, online lenders, and credit unions. Find out which will offer you the best terms.Improve your credit score. Before applying for a loan, check your credit report to remove any errors. You can also try to improve your credit score by paying down existing debt, which will improve your credit utilization ratio. It may be worth taking on a side job for a while to find extra money for timely debt repayment before getting a loan.Make a larger down payment. The more you put down, the less risk the lender takes on. Borrowing less can not only help you qualify for a better rate, but you will also pay less interest since your interest is being charged on a smaller balance.
If you itemize on your taxes, your mortgage interest may also be deductible on loans up to $750,000.
Taxes and insurance
Finally, your mortgage lender may also require you to make payments toward property taxes and home insurance. That’s not because the lender provides insurance or taxes your home. Instead, this money is collected in an escrow account and used to pay the tax and insurance bills when they come due.
Lenders require you to put money into escrow because they want to ensure there are funds available to pay to keep the home insured and to pay the property taxes. This is important since the home is the collateral for the loan and they don’t want a tax lien on it or for the house to be destroyed with no insurance.
Now you know where your monthly mortgage payment goes: principal, interest, taxes, and insurance (PITI). It’s important to understand this, and to make sure you keep your total housing costs affordable by aiming to keep your PITI below 28% of your income and your total debts, including PITI below 36%. If you can do that, you can avoid being “house poor” and should be able to make monthly housing payments without compromising other financial goals.
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