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Financial Literacy
How Mortgages Work
Principal, interest, and the 30-year payoff
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A mortgage is a long-term loan used to buy a home, and it is one of the biggest financial decisions many people make. Instead of paying the full home price at once, the buyer pays a down payment and borrows the rest from a lender. The loan is repaid through monthly payments over many years, often 30 years. Understanding how those payments work helps students see the real cost of borrowing money.
Key Facts
- Loan amount = Home price - Down payment
- For a 60,000 and loan amount = $240,000
- Monthly payment for principal and interest: M = P[r(1 + r)^n] / [(1 + r)^n - 1]
- For a 1,517 per month
- Total paid on the loan = Monthly payment x Number of payments
- Escrow can add property taxes and homeowners insurance to the monthly payment, so the total payment is more than principal and interest
Vocabulary
- Mortgage
- A mortgage is a loan used to buy real estate, with the property serving as security for the lender.
- Principal
- Principal is the amount of borrowed money that has not yet been repaid.
- Interest
- Interest is the cost of borrowing money, usually shown as a yearly percentage rate.
- Escrow
- Escrow is an account used by the lender to collect and pay costs such as property taxes and insurance.
- PMI
- PMI, or private mortgage insurance, is an extra cost often required when the down payment is less than 20%.
Common Mistakes to Avoid
- Confusing the home price with the loan amount. The loan amount is usually smaller because the buyer pays a down payment first.
- Thinking the monthly mortgage payment is only the loan payment. The full payment may also include property taxes, homeowners insurance, PMI, and other costs.
- Assuming equal payments mean equal principal payments. Early in a 30-year mortgage, more of each payment goes to interest, while later more goes to principal.
- Ignoring the interest rate when comparing homes. A higher APR can make the same home much more expensive over the life of the loan.
Practice Questions
- 1 A home costs $300,000 and the buyer makes a 10% down payment. How much is the down payment, and how much is borrowed?
- 2 A borrower pays 240,000?
- 3 Two buyers purchase the same $300,000 home. Buyer A makes a 20% down payment, while Buyer B makes a 5% down payment. Explain why Buyer B may have a higher monthly payment even if the interest rate is the same.