How does a mortgage work? A walk through the numbers
Buying a home. For most of us, it’s the ultimate take-a-deep-breath purchase we’ll make—and that’s without all the complexities surrounding the mortgage.
A home is such a big purchase that you’ll likely need to borrow money in order to close the deal. But how does a mortgage work? And what does it mean to “build equity in your home” as you pay down your mortgage?
Let’s take a look at the basics of mortgages, how they work, and what you need to know about building ownership in your home.
Key Points
- Equity represents your ownership in the home versus the mortgage lender’s stake.
- Your equity builds as you pay down the mortgage, and when it’s paid off, your equity stake is 100%.
- A mortgage calculator can help you understand how quickly you’ll build equity.
How does a mortgage work?
A mortgage is a loan used to buy your home. You borrow money from a bank or credit union to make your home purchase. The lender allows you to repay your home over a set period of time, usually between 15 and 30 years.
However, in order to use the lender’s money, the lender (typically a bank) will charge interest. So your total mortgage amount includes the original amount you borrow, plus the interest you pay to the lender as a fee for using their financial resources.
Use a down payment to reduce what you borrow
You can reduce your mortgage payment and the resulting interest charges by borrowing less. A down payment is a way to reduce how much you borrow. Let’s say you’re interested in a $400,000 home. You use a down payment of 20%, or $80,000, as part of the homebuying process.
Because you brought $80,000 to the table, you borrowed $320,000 instead of the full amount. If you have a 6.52% interest rate on a 30-year fixed loan, that can make a big difference in what you pay overall.
| Amount borrowed | $400,000 (zero down) | $360,000 (10% down) | $320,000 (20% down) |
|---|---|---|---|
| Loan payment | $2,533 | $2,280 | $2,026 |
| Total repayment | $912,425 | $821,002 | $730,280 |
Even if you can’t save up a full 20% for a down payment, bringing some money to the transaction can reduce what you pay overall. But the less you put down, the more likely it is that your lender will require private mortgage insurance (PMI)—more on that below.
If you’re interested in learning more about the numbers (including different loan amounts, interest rates, and payment terms), play around with the numbers using the Loan Calculator in the sidebar.
What’s in a monthly mortgage payment?
Your monthly payment is typically made up of several parts, depending on the arrangement between you and your lender. Here are some items that might make up your monthly mortgage payment.
- Principal: The original amount you borrow.
- Interest: The fee the lender charges for using their money. It’s assessed on the outstanding principal balance.
- Property taxes: In some localities, your property taxes are paid along with your mortgage. In others, you’ll receive your tax assessment directly from your county assessor’s office. It’s important to know which regime you’ll be following.
- Homeowner’s insurance: You might make your home insurance payments at the same time as your mortgage. Or you might be responsible for paying your insurance company directly, but your lender might require proof.
- Private mortgage insurance (PMI): If you put down less than 20%, you might be subject to PMI, which is essentially an insurance policy that covers your lender in case you default and the home’s value isn’t enough to cover the mortgage’s outstanding principal balance. PMI doesn’t reduce your principal, but if you’re required to pay it, your monthly payment will be higher.
Principal and interest represent the actual loan part of your monthly mortgage payment. Property taxes and insurance might be tacked on separately using what’s called an escrow account.
Escrow defined
An escrow account is a separate account designed to save up money for homeowner’s insurance premiums and property taxes. Some lenders require it, particularly if you start with a down payment of less than 20%. If you’re participating in an escrow program, your lender will collect this extra amount as part of your monthly loan payment and set it aside to make tax and insurance payments on your behalf.
If you have a fixed-rate mortgage, your principal and interest payments will remain the same throughout your loan term. However, if you have an escrow account, your monthly mortgage payment could change based on rising property taxes, as well as changes to your insurance premiums.
When you have an adjustable-rate mortgage, your payment will change if interest rates rise or fall. On top of that, if you’re paying taxes and insurance through escrow, you could see even bigger swings to your monthly mortgage payment.
Choosing a mortgage type?
For more on fixed versus adjustable-rate mortgages (ARMs), read this overview.
Pay attention to which part of your mortgage payment is principal and interest (P&I), and which part is going to escrow. If you don’t have an escrow account, you will pay your homeowner’s insurance premiums and property taxes on your own, so it’s a good idea to save up for these costs.
Here’s an example of how extra costs can increase your payment, assuming a 30-year fixed-rate mortgage of $360,000 at 6.52%:
- Principal and interest: $2,280
- Property tax payment (escrow): $263
- Homeowner’s insurance (escrow): $66
- PMI (escrow): $90
- Total monthly payment: $2,699
Your own numbers will depend on where you live, how much the lender charges for PMI, and other factors. You can use a monthly payment calculator to get an idea of how much you might pay depending on where you live.
How does mortgage interest work?
Because mortgage interest is such a big part of your total cost, it’s important to understand how it works. That interest is an extra fee and doesn’t reduce your mortgage principal. In general, at the beginning of your mortgage, a bigger portion of your mortgage payment goes to interest.
For example, suppose you get a 30-year fixed-rate loan for $360,000 at 6.52% (with a monthly P&I of $2,280, according to the mortgage calculator) and you make your first P&I payment in February 2023. The following table shows how it will break down over time:
| Payment date | Principal | Interest |
|---|---|---|
| February 2023 (first) | $324 | $1,956 |
| August 2039 | $947.31 | $1,332.69 |
| January 2053 (last) | $2,468.80 | $13.41 |
Why? Amortization. Mortgage interest is assessed each month on the outstanding principal balance. But your payments are fixed according to a so-called “amortization” schedule. Amortization is a fancy way of saying “paying down the principal balance.” So in that first month, that $2,280 is mostly paying interest—you’re only amortizing $324.
But the next month, your principal balance would be $359,676 ($360,000 – $324). So that next $2,280 payment will allocate a wee bit more to the principal part, and you’ll pay a wee bit less in interest.
Over time, the amortization skews more heavily toward principal, and your last monthly payment will go almost entirely toward principal.
Equity and building ownership in your home
When you have a mortgage, you basically share ownership of your home with the lender. After all, they fronted the money for the purchase. If you don’t make payments, they have the right to evict you from your home and take ownership.
Equity is a common mortgage term that refers to how much ownership in your home you can access. Your equity is determined by the appraised value of your home minus the outstanding balance on your mortgage. Here’s a simple example using a 20% down payment:
- You buy a $400,000 home, using a down payment of 20% (or $80,000). Your mortgage is $320,000. The $80,000 you used for a down payment represents your current home equity.
- Five years go by, and you’ve paid down $40,000 in principal, taking your principal balance down to $280,000. Meanwhile, the housing market went up and your house now appraises for $500,000.
- Appraised value – outstanding balance = home equity $500,000 – $280,000 = $220,000
The bigger your down payment, the larger your chunk of equity—and the faster you’re able to build more equity in your home.
And remember: Your equity share improves each month, as a larger chunk of your payment goes toward paying down your principal rather than paying your mortgage fees.
The bottom line
Your mortgage is more than just a tool to help you buy a house with borrowed money. It’s a way to sidestep monthly rent payments, build equity, and plant roots. But it’s most effective if you plan to stay put for a while.
Depending on your lender, your mortgage payment may also include escrow payments—money set aside to cover your property taxes and homeowner’s insurance (and PMI, if required).
And remember the dynamics of mortgage interest. In the early months, your payments are mostly interest. But lenders typically let you make “extra” principal payments. So if you get a windfall bonus or unexpected tax refund, consider paying down your principal. It works on the same concept as compounding interest, but instead of accelerating the return on your savings, you’re decelerating your interest costs.