If you have a mortgage, your monthly payments go toward a variety of purposes. There is a part that goes toward your outstanding balance, another part goes toward your accrued interest, and the rest, handled by an escrow company, goes toward insurance premiums and tax payments. Learning how to differentiate the various parts of your payment helps you to understand how your mortgage evolves over time.
When you pay toward the principal on your mortgage, you are paying toward the original debt. When you pay toward escrow, you are setting aside funds to pay future interest, homeowners insurance and property taxes.
Paying to the Principal
When you pay to a mortgage's principal, you are paying toward the outstanding balance of the loan. Mortgage balances are divided into two: the mortgage itself and its associated interest. When a home owner pays into a mortgage, a part of the payment goes toward the accrued interest on the account while the rest goes toward the mortgage's principal.
This effectively lowers the principal, and any interest accrued each month will be lower, provided that your interest rate has not changed. This is because your interest rate is always a percentage of your outstanding principal.
Paying to the Principal: Example
Assume you have taken out a mortgage worth $100,000. This $100,000 represents the principal of the loan. Your interest rate for the mortgage is 5 percent, which remains fixed for the lifetime of your loan. Dividing by 12, your monthly interest rate is 0.4167 percent, rounded to the nearest ten-thousandth of a percent.
In the first month, you pay $500 toward your mortgage. You find that your principal has fallen from $100,000 to $99,583.33. This is because you have paid $416.67 of your $500 toward interest, while $83.33 went toward the principal. In the next month, the accrued interest will fall to $414.93, while $85.07 goes toward the principal.
Paying to Escrow
An escrow account is a type of safe-holding account that comes with a mortgage. It stores a portion of the monthly payments made toward your mortgage and accumulates them to pay for certain expenses. These expenses are usually mortgage insurance premiums, hazard insurance premiums and property taxes.
Escrow accounts have two advantages. The first is that they allow the account holder to budget payments for the future instead of paying one lump sum at a future date. It is easier paying $100 every month instead of $1,200 at the end of the year. The second advantage is that, as a result of the budgeting that arises from escrow, mortgages become cheaper because the lender knows that the borrower will be more reliable with his payments.
Paying to Escrow: An Example
Using the same example, assume that in addition to the $500 that goes toward your mortgage, an extra $50 goes toward into an escrow account. Your hazard insurance premiums are $5 a month, leaving $45 left of every monthly escrow payment. These payments accumulate for 12 months, when, at the end of January, they amount to $540. Of this, $400, on your behalf, goes toward taxes. The rest, $140, goes toward mortgage insurance.