How Mortgage's Work

An easy-to-understand explanation of how mortgages work

A mortgage is a long-term loan that a borrower obtains from a bank, mortgage broker, online bank, or other financial entity. The term of these loans varies, but the most common lengths are 15 and 30 years.

Lenders secure the loans by using the house and the land that the house sits on as collateral. If the borrower defaults on the loan, the bank is able to seize (foreclose) on the property by exercising its lien on the property. Borrowers sign many documents at closing to give the lender this legal authority.

The inverse relationship between principal and interest

At the onset of a mortgage, the bulk of the principal and interest (P&I) payment is applied toward interest. As time goes on, the relationship shifts with the principal eventually becoming the larger portion of the payment.

In most cases, escrow payments (property taxes and homeowner's insurance) are included in the mortgage payment. These payments are called PITI payments, so named to form an acronym for the following payment elements:

  • Principal - The loan balance.
  • Interest - Interest owed on the loan balance.
  • Taxes - Real estate taxes assessed by local governments (city, county, etc.) to fund services including; schools, fire services and other municipal projects.
  • Insurance - Homeowner's insurance to cover loss caused by theft, fire, and other disasters.
Payment Number Principal Payment Payment Amount Interest paid Principal Applied New Ballance
1 $150,000 $1048.82 $937.50 $111.32 $149,888
60 $142.086 $1048.82 $888.04 $160,78 $141,926
120 $130,426 $1048.82 $815.16 $233.66 $130,192
240 $88,851 $1048.82 $555.32 $493.50 $88,358
359 $2,078 $1048.82 $12.99 $1035.83 $1042

The above table illustrates how amortization works and uses a 30 year, fixed rate (7.5 percent) mortgage, with a $150,000 beginning balance, and assumes that the borrower will repay the loan over the full 30 year term. The interest payment over the life of this loan will be $227,575.83. The monthly payment will be $1,048.82 over the life of the loan.

The inverse relationship between principal and interest is clearly shown in the table. During the first month, only $111.32 is applied to the principal while $937.50 is applied to interest. By the time the second to last payment is made, $1035.83 will be applied to interest and only $$12.99 will be applied to interest.