Intro: How Mortgages Work

A mortgage is a long-term loan that a borrower obtains from a bank, thrift, independent mortgage broker, online lender, or even the property seller. The house and the land it sits on serve as collateral for the loan. The borrower signs documents at closing that give the lender a lien against the property. A lien gives the lender the power to take the home through foreclosure if the borrower doesn't make payments as agreed. Because mortgages are such large loans, consumers repay them over long periods, usually 15 to 30 years. Monthly payments gradually whittle away the principal balance, slowly at first then rapidly toward the end of the loan.

What's in a payment?

When escrow is used, a monthly mortgage payment is called a PITI payment. That's because each one covers a portion of the following four costs.

• Principal: the loan balance
• Interest: interest owed on that balance
• Real estate taxes: taxes assessed by different government agencies to pay for school construction, fire department service, etc.
• Property insurance: insurance coverage against theft, fire, hurricanes, and other disasters

Most lenders require taxes and insurance to be paid out of escrow. Such a policy protects the lender from tax liens and uninsured losses that the borrower can't repay. Infrequently, the lender will allow a borrower to pay property taxes and insurance in lump sums when they come due. Depending on the kind of mortgage a borrower has, the monthly payment might include a separate levy for mortgage insurance.

Amortization

The breakdown of each payment changes over time because mortgages are based on a repayment formula called amortization. That's a fancy term meaning the lender not only spreads the interest you owe on the mortgage over hundreds of payments but front-loads the interest too. Early in the mortgage, most of your payment goes to interest. Late in the mortgage, most goes to principal.