When you're looking to purchase a home, it's important to understand the components of a mortgage. Equity, interest, escrow accounts, and private mortgage insurance are all important factors that make up a mortgage payment. Equity is the amount of money you borrowed to buy your home or the amount of the loan you haven't yet repaid. Interest is the cost you pay to borrow money from your lender, and it usually appears as a percentage of the amount you borrowed.
Interest rates are set by your lender based on many factors, some of which you can control and others you can't. Of those you can control, one of the most important factors is your credit rating. A higher credit score could help you get a lower interest rate. Required by many lenders under the terms of your mortgage, an escrow account is a reserve set aside to pay a portion of your annual property tax costs and insurance premiums, such as homeowners insurance.
Your escrow payment goes to your lender, who deposits the money into an escrow account. The lender uses the money in the escrow account to pay your property taxes and insurance premiums on your behalf when they are due. Regularly scheduled escrow payments are a good option for many homeowners because they eliminate the surprise of a large annual payment for those expenses. Your mortgage payment will generally include one-twelfth of the estimated annual real estate taxes, also known as property taxes, on the home you purchased. These payments are deposited into an escrow account and the lender will use the funds to pay your property taxes on your behalf when they are due.
Your mortgage payment will also generally include one-twelfth of your annual homeowners insurance premium that will be deposited into an escrow account. Like your taxes, when your insurance expires, your lender will use the money in that account to pay homeowners insurance on your behalf. If your down payment is less than 20%, you'll need to purchase private mortgage insurance, an additional insurance policy that protects the lender if you can't pay your mortgage. As with your taxes and homeowners insurance, one-twelfth of your annual mortgage insurance premium is included in your monthly payment and deposited into your escrow account. Your lender will use these funds to pay for your insurance on your behalf when it expires. The mortgage repayment program provides a detailed view of what part of each mortgage payment is dedicated to each component of the PITI (Principal, Interest, Taxes and Insurance).
Understanding these components can help you choose the mortgage option that best suits your needs. Two of these components, property taxes and insurance, can be part of what is called an escrow account. To determine how much housing you can afford, keep in mind that each component will affect the amount of your monthly payment because a mortgage payment consists of much more than just the amount borrowed. When you understand how these components work together and how they can affect capital, you're in a better position to manage it.