Mortgage Guide

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. Sometimes, but not often, 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.

The breakdown of each payment (the amount that goes toward principal, interest, etc.) changes over time because mortgages are based on a repayment formula called amortization. That's a fancy term meaning the lender spreads the interest you owe on the mortgage over hundreds of payments. This keeps the monthly payments low.

How does amortization work?

How principal and interest change over the life of a loan

Payment NumberPrincipal BalancePayment AmountInterest PaidPrincipal AppliedNew Balance
1$150,000$1,048.82$937.50$111.32$149,888.68
60$142,086.93$1,048.82$888.04$160.78$141,926.15
120$130,426.14$1,048.82$815.16$233.66$130,192.48
240$88,851.22$1,048.82$555.32$493.50$88,357.72
359 (next to last)$2,078.14$1,048.82$12.99$1,035.83$1,042.3

On a 30-year, $150,000 mortgage with a fixed interest rate of 7.5 percent, a homeowner who keeps the loan for the full term will pay $227,575.83 in interest.

The lender does not expect that person to pay all that interest in just a couple of years so the interest is spread over the full 30-year term. That keeps the monthly payment at $1,048.82.

The only way to keep the payments stable is to have the majority of each month's payment go toward interest during the early years of the loan. Of the first month's payment, for instance, only $111.32 goes toward principal. The other $937.50 goes toward interest. That ratio gradually improves over time, and by the second-to-last payment, $1,035.83 of the borrower's payment will apply to principal while just $12.99 will go toward interest.