A mortgage payment looks like one number and is actually four, mixed together in proportions that change every month. Taking it apart makes most of the vocabulary that surrounds borrowing self-explanatory. Nothing on this page recommends a structure or assesses anyone's circumstances.
The four parts of a payment
A typical monthly payment consists of interest on the outstanding balance, a repayment of some of that balance, an amount collected toward property tax, and an amount collected toward insurance. Only the first two are the loan. The last two are money passing through the lender on the way somewhere else, held in an escrow account and paid out when the bills fall due.
That distinction matters when a payment changes for no apparent reason. A fixed-rate loan's principal and interest do not change; the tax and insurance portions do, and adjustments to the escrow account are the ordinary explanation for a payment that moves on a loan whose rate did not.
How amortisation actually behaves
Interest is charged on the balance that remains. At the start of a long loan the balance is at its largest, so most of a level payment is consumed by interest and only a little reduces the debt. As the balance falls, the interest share falls with it and the repayment share grows, slowly at first and then quite quickly toward the end.
Two consequences follow. Extra payments made early remove far more total interest than the same amount paid late, because they remove balance that would otherwise have accrued interest for many years. And a loan refinanced into a fresh long term restarts this curve, which can lower the monthly payment while raising the total interest paid, depending on the rate and the term chosen.
Fixed and adjustable structures
A fixed rate holds for the life of the loan, so the borrower carries no interest-rate risk and the lender carries all of it. That certainty is priced: fixed rates generally start above the initial rate of a comparable adjustable loan.
An adjustable rate holds for an initial period and then resets periodically against a published index plus a fixed margin, within caps that limit how far it can move at each reset and in total. The borrower carries the rate risk in exchange for the lower initial rate. Understanding one means knowing four things: the index, the margin, the reset frequency and the caps.
Points, and what a rate prices
A point is a fee paid at the outset, expressed as a percentage of the loan, in exchange for a lower rate over its life. It is a straightforward trade of money now against money later, and the only question it raises is arithmetical: how long the loan must be held for the reduced payments to recover the sum paid.
A quoted rate itself prices several things at once: the general cost of long money, the lender's assessment of credit risk, the proportion of value being lent, and the cost of the option the borrower holds to repay early. Two rates quoted on the same day for the same property can differ for reasons entirely internal to those four.
Vocabulary worth having
- Principal. The amount still owed, on which interest is calculated.
- Term. The period over which the balance is scheduled to reach zero.
- Loan-to-value. The proportion of the property's value being borrowed.
- Escrow account. The lender-held account through which tax and insurance are paid.
- Amortisation schedule. The month-by-month table of how each payment divides.