What is a Mortgage?
A mortgage is a loan to finance the purchase of a home, and it is probably the largest debt you'll ever take on. When you purchase a home with a mortgage, you are using borrowed money to help you pay the home's sales price. Without a mortgage loan, you would have to pay for the home with all cash. To repay the mortgage debt, you make monthly installments or payments back to the financial institution that issued you the loan. These payments typically include the principal, interest, taxes and insurance, together known as PITI.
Principal and Interest (The "PI" in PITI)
Principal: The principal is the sum of money you borrowed to buy your home. For instance, if you borrowed $100,000 to buy your home, then your total principal would be $100,000. This is the amount that you have to pay back to the lender. Once you've done this, then you will own the house outright.
Interest: Usually expressed as a percentage called the interest rate, interest is what the lender charges you to use the money you borrowed. Lenders charge you interest, because in most cases, they are a business, and that is how they make their money.
Principal and interest comprise the bulk of your monthly payments. The process of making your monthly payments is called amortization, which reduces your debt over a fixed period of time. Each payment includes both an interest payment portion and a principal payment portion, although the ratio of principal to interest that you pay in each given month changes over time.
Taxes and Insurance (The "TI" in PITI)
In addition to your principal and interest, your mortgage payment could include money that's deposited in an escrow account to pay certain taxes and insurance.
Generally, if your down payment is less than 20 percent of the loan, your lender considers your loan riskier than those with larger down payments. To offset that risk, the lender sets up an account to collect your tax and insurance payments, in advance, so that they can ensure that these expenses are paid.
Taxes: The taxes are property taxes your community levies based on a percentage of the value of your home. The tax is generally used to help finance the cost of running your community, e.g., to build schools, roads, infrastructure and other needs.
Insurance: Lenders won't let you close the deal on your home purchase if you don't have home insurance (also called hazard insurance), which covers your home and your personal property against losses from fire, theft, bad weather and other causes. Even if you pay cash for your home, you should buy home insurance unless you can afford to repair or rebuild your home if it's damaged or destroyed.
If your home is in a federally designated high flood risk zone within a flood plain and you are signing for a federally insured loan, federal law mandates that you must buy flood insurance. If you are not in a high flood risk zone, you can still buy the coverage.
PMI (Private Mortgage Insurance)
If your down payment is less than 20 percent (or the percent amount accepted by lenders) of your home purchase some lenders will also charge you private mortgage insurance (PMI) premiums. The coverage doesn't protect you, it protects the lender from you defaulting on the mortgage. PMI is what helps lenders feel more comfortable about giving loans to individuals who don't have enough cash to make a 20% down payment on the home.
Tax Deductions
Here's the great news about mortgage payments, though. Unlike your rent payment, most of your mortgage payment is tax deductible. In other words, of the PITI, the "ITI" are all tax deductible, and so is the PMI, which means that you could see a sizable tax rebate every year from the IRS!