What's in a mortgage payment: principal, interest, tax and PMI

A monthly mortgage payment is usually the principal and interest on the loan, plus property tax and homeowners insurance, which are often collected into an escrow account. If your down payment is under 20% of the price, a conventional lender usually adds private mortgage insurance (PMI) too. On a $320,000 loan at 6.5% over 30 years, the principal and interest come to $2,022.62 a month. The other parts are added on top, and their size depends on where you live and what you pay for insurance.

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The parts of the payment

Lenders often describe the monthly payment as PITI.

• Principal: the part that reduces what you owe.
• Interest: the lender's charge for the money, which is calculated on the balance you still owe.
• Taxes: property tax, set by the local authority.
• Insurance: homeowners insurance, and sometimes flood insurance.

PMI is an extra cost when the loan is large compared with the home's value. HOA dues, if your home is in an association, are paid separately from the mortgage.

Escrow works like this: each month the lender takes a share of the year's property tax and insurance bills and holds it, then pays the bills when they are due. Because tax and insurance can change, the escrow amount and the total payment can change even on a fixed-rate loan. Your annual escrow statement shows what was collected and paid.

The formula, with an example

The principal and interest payment is calculated with this formula:

M = P × r ÷ (1 − (1 + r)^−n)

Here P is the loan amount, r is the annual rate divided by 12, and n is the number of monthly payments.

Take a $400,000 home bought with 20% down, at 6.5% over 30 years.

• P = 400,000 × (1 − 0.20) = $320,000
• r = 0.065 ÷ 12 = 0.0054167
• n = 30 × 12 = 360

The monthly principal and interest is $2,022.62. Over the full 30 years, that is about $408,000 of interest on top of the $320,000 borrowed.

Why early payments are mostly interest

Interest for a month is the balance times r. At the start the balance is large, so most of each payment is interest. In the first month, $320,000 × 0.065 ÷ 12 is $1,733.33 of interest, so only $289.29 of the $2,022.62 reduces the loan.

Over the first year, about 85% of the principal and interest paid goes to interest. The balance falls slowly at first:

After	Balance still owed
Year 0	$320,000.00
Year 10	$271,283.60
Year 15	$232,189.25
Year 20	$178,128.90
Year 25	$103,373.32
Year 30	$0

This is why the first years of a mortgage build equity slowly, and why selling early often means paying off a balance that is still close to the original loan.

PMI and when it ends

PMI is usually charged on conventional loans when the down payment is less than 20%. The cost depends on the lender, your credit and the size of the loan, so ask for the figure in writing before you buy.

The Homeowners Protection Act of 1998, also called the PMI Cancellation Act, sets the rules for ending it. As described in the National Credit Union Administration's guide to the Act:

• You can ask the lender to cancel PMI once the scheduled principal balance reaches 80% of the home's original value. You may also ask earlier, once actual payments bring the balance to 80%. You need a good payment history, your lender must be satisfied that the property's value has not declined, and the property must not have subordinate liens.
• The lender must end PMI automatically when the scheduled balance reaches 78% of the original value, if the loan is current.
• For high-risk loans, PMI generally cannot continue past the midpoint of the loan's term if the loan is current.

Take a $400,000 home with 10% down, so a $360,000 loan at 6.5% over 30 years. The payment is $2,275.44. On the standard schedule, the balance falls below 80% of the home's value, $320,000, in month 95, and below 78%, $312,000, in month 109. Those dates are based on scheduled payments. Extra payments can bring them forward, and you should ask the lender for the date in writing.

What extra payments do

An extra $200 a month on the $320,000 loan above changes the result considerably. Without extra payments, the loan runs for 360 months. With $200 a month extra, it is paid off in 281 months, which is 79 months earlier. Total interest falls from $408,142 to $302,714, a saving of $105,428.67.

Two checks before you start. Tell the lender in writing that extra money should go to principal, not to the next payment, and read your loan papers for any prepayment clause.

Quick answers

Why did my payment not go down after I paid extra? A lower payment is not the usual result. Extra payments normally shorten the loan. Check that the lender applied the money to principal.

Is the interest rate the same as the APR? No. The APR includes some fees, so it is usually higher than the rate. APR vs interest rate explains the difference.

Can I use the same method for other loans? Yes. The loan calculator works for car loans and personal loans, and the same amortisation logic applies. For savings, the compound interest calculator shows the opposite effect.