Principal, interest, taxes, and insurance form the four (4) basic components of a mortgage that require payments on a monthly or yearly basis. Lending institutions try to facilitate this process by offering escrow services to collect one monthly payment to cover all four components. Some lenders allow homeowners to pay their own property taxes and home insurance premiums, but they could raise the interest rate to compensate for accepting a higher risk payment arrangement. It is critical that you review your escrow arrangement to make sure you did not consent to accept a higher interest rate in return for controlling your tax and insurance yearly payments.

How to

To help you fully understand each component, here is a detailed listing on each of the four components of a mortgage:

1. Principal

- The amount you agreed to finance with a lending institution
  - Most commonly, buyers finance between 80% and 95% of the selling price of the property
  - The principal in a mortgage is the amount a borrower has to pay over the life of the loan

2. Interest

- The amount the lending institution will receive as a compensation for lending you a loan to buy your house
- The interest amount of a mortgage can be three (3) times the amount of the principal over the life of the loan
  - It is imperative you run an amortization schedule to show the breakdown between principal and interest payments over the life of the loan

3. Property taxes

- These are also known as "ad valorem" tax, meaning the property is taxed according to its assessed value
- The property taxes are enforced locally by your county, city, or school district and the assessed value is determined by the local taxing authorities
  - Taxing percentages are different depending on locations
  - It is critical you find out the taxing obligations on properties prior to purchasing your next home

4. Insurances

- There are two types of insurances that might be required for a mortgage
- Those two types of insurances are homeowner's insurance and private mortgage insurance
  - Homeowner's insurance:
    - A standard requirement to get a mortgage
    - It is a security against any property loss
    - Some areas have special requirements for hazard insurance such as flood, earthquake, wind, and fire damage
  - Private mortgage insurance:
    - To protect the lender in case you fail to make your mortgage payments
    - A buyer is usually required to purchase a private mortgage insurance if the down payment is less than 20% of the property purchase price

Practice

Now that you know the four basic components of a mortgage, think of paying it forward and discuss these components with a friend or a family member.

Congratulations! You can move on to Chapter 3. First time home buyer - The search process

To review the full module on Mortgage, click here.