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Understanding Payments & Escrows

A mortgage payment is comprised of much more than a traditional consumer loan. Principal, Interest, Insurance, and Taxes may all be built into your payment. Eventually you’re going to ask the obvious question, “How is this all going to be paid, and what is this going to cost?”

The “Parts”
Payments on your mortgage will be divided into different “parts”. All lenders will collect for accrued interest on a periodic basis and most will provide for principal reduction as well. Some lenders will also collect for the escrow of property taxes and hazard insurance premiums.

How much goes to principal and interest?
First of all, let’s define some terms. Principal is the amount you borrowed, or the balance remaining after payments begin. Interest is the amount the lender charges you for loaning you the money. Interest is accrued on the unpaid balance and is collected by the lender before any remaining portion is applied to principal.

On a loan with a thirty-year repayment schedule, most of the principal and interest payment goes to interest in the early years. As an example, on a loan with a fixed rate of 8.250%, monthly payments (the combination of principal and interest) would be $702.04. Even after a year of payments, only $20.00 is actually applied to principal. It takes over twenty-two years before the monthly payment is evenly distributed between principal and interest. Using a thirty-year term will thus keep payments as low as possible, but total interest paid over the life of the loan is high. Naturally, a shorter term loan would mean less interest, but would also yield a higher monthly payment.

Escrow… what’s that?
An escrow account is balance held by the lender for payment of property taxes, hazard insurance premiums and private mortgage insurance premiums (if necessary). Most lenders will require escrow accounts for borrowers with less than a twenty percent down payment. There is greater risk to the lender when borrowers make lower down payments. To make sure that taxes and insurance premiums are being paid, the lender automatically makes those payments for the borrower from this escrow account.

The account will start with a balance the borrower pays at closing. Consider this your “head start” toward the funds that will ultimately be needed when taxes and insurance premiums are due. Additional funds are collected with monthly payments. The monthly amount for escrows is usually one twelfth of the estimated annual property taxes and annual insurance premiums. The nice thing about escrowing for tax and insurance is that a borrower doesn’t have to worry about where the funds are going to come from when the taxes and insurance premiums are due. Further, most states require lenders to pay interest on escrow accounts.

If your lender doesn’t require you to escrow for taxes and insurance, you may want to do this on your own, by simply making a monthly deposit in a savings account. Transfer from this account to pay taxes and insurance premiums. Most financial institutions can automate a monthly deposit to a special savings account from your checking. Some institutions, particularly credit unions, can set up such deposits through payroll deduction with your employer.

Ways to save money on interest
Beyond shopping for a good rate, there are ways of saving on mortgage interest. Providing there are no prepayment penalties, borrowers can save on interest by applying additional funds to principal. This might be done either by increasing your monthly payment or by applying a lump sum to the loan. Policies pertaining to accelerating payments vary from lender to lender. Check with your lender how this might be handled in your case.

Note: As attractive as such savings may seem, don’t apply additional funds to your mortgage without considering a number of factors – Do you have adequate savings or emergency reserves? Are you saving enough for retirement or education expenses? Do you have other outstanding loans at higher interest rates? Does this make sense tax-wise?

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