Buying a house is one of the most important financial decisions most people are going to make in their life, and the majority need to take out a mortgage to be able to do it. A mortgage is a substantial long-term commitment to make, and as such, it’s crucial to acquaint yourself with its various concepts. For a first-time buyer who has not done it before, it might seem a bit intimidating from afar. But once you get through the basics and understand the jargon, you’ll feel much more confident about your decisions before taking on debt.

What Is a Mortgage?

A mortgage is a collateralized loan. It’s basically a loan secured on a property where the lender—which is usually a financial institution such as a bank—reserves the right to take ownership of the property should the borrower fail to fully repay it. Mortgages are taken out on either a property that the borrower plans to buy or on a property they currently own in order to raise funds for other purposes. In return for that security, these loans usually have low-interest rates compared to other unsecured types of loans.

LTV and Down Payment

Since financial institutions rely on selling the collateral to recoup their initial loan amount, and property prices are not fixed and tend to fluctuate over time, lenders don’t lend the full value of a property. Rather, they lend a percentage of the property’s full value to the borrower, which is called the Loan-to-Value ratio or LTV. This ratio is basically a risk assessment tool for the lending institution to see how much of its initial investment can be recovered should the borrower default on the loan.

From the lender’s perspective, high LTV mortgages are considered high-risk investments. Therefore, their interest rates tend to be higher, and they are harder to come by. This is why most buyers need to save to pay a percentage of the house they are going to buy as a deposit.

For the sake of simplicity, let’s say you plan to buy a house whose value on the market is $100,000, and you have $20,000 in your savings to put down. Hence, you need an $80,000 mortgage with a Loan-to-Value ratio of 80%, which in this case is an ideal amount.

Mortgage Payment and Its Components

A mortgage loan is typically repaid over a 15, 20, or 30-year period, which is usually referred to as the loan’s term. As to how the payment works and how the installments are calculated, you need to know the four factors referred to as PITI.

Principal

The principal is simply the exact amount of the loan you get from the bank in order to be able to purchase the house. In the example that we provided above, the principal amount you owe is $80,000.

Interest

The interest is practically the amount of money you give to a financial institution to compensate them for lending you the principal amount for the loan’s term. It is expressed as a percentage rate, and it is proportionate to the amount of risk the loan imposes on the lender. The risk involved is determined by things such as the borrower’s credit score, the loan to value ratio, etc.

Taxes

These are the property taxes associated with owning the house you buy with the loan. These taxes are calculated based on the assessed value of the house and are typically rolled into your regular mortgage payment. They are escrowed in a separate account and are paid when they are due.

Insurance

Property insurance is a protective measure that provides financial support to help pay for losses in the event of disasters. Just like taxes, property insurance is paid by the borrower as a part of the monthly mortgage bill. However, insurance in PITI may also include private mortgage insurance, which is usually required if the borrower of a conventional loan puts less than 20% down on a property, and it’s there to protect the lender.

How does It work?

Since the vast majority of mortgages are amortized loans, the amount of money you will have paid by the end of the term consists of two parts, which are the interest and the principal. Sticking to our example, let’s say we get a mortgage of $80,000 at an annual interest rate of 4% for 30 years. Using the loan calculator amortization formula, our monthly payment would be $381.93, which includes two portions that go into both the interest and the principal amount. Since almost all mortgages are front-loaded—meaning you pay off the interest first—the majority of your early payments are not deducted from the principal amount.

In order to calculate what portion of our first $381.93 payment goes toward the interest, we multiply the balance of $80,000 times the annual interest rate of 0.04 and divide it by 12 to get $266.67. This means that only $115.26 of our $381.93 payment is deducted from the principal amount. The principal-to-interest ratio gradually increases with each payment, and you’ll pay less interest by the month. In this way, by the end of the 360th month, we have paid a total interest of $57,495.61, in addition to the $80,000 principal amount. By decreasing the mortgage term or paying some amount in addition to the monthly payments, we can significantly decrease the total interest paid.