Most people who have a mortgage probably think what they send off to the lender each month covers only what they borrowed plus the interest. But that payment may cover funds that go to other sources, including taxes and insurance. When making your payment, it's important to understand the difference between principal and escrow.
Your mortgage principal refers to the amount owed on the loan, excluding interest charges. Your escrow account is where you deposit money to pay later for things like property taxes, insurance and homeowner's association fees.
Understanding the Loan Principal
When talking about a loan, the principal is the amount of money you owe, not counting interest. If you took out a loan for $150,000, that's your principal. Likewise, if you owe $50,000 after paying your mortgage for 20 years, that's the amount of principal remaining.
How an Escrow Account Works
An escrow account is simply an account controlled by a third party into which you deposit money to pay for something at a later date. When you buy a home, you will put money into escrow for things such as property taxes that might be due on your home. Most lenders require you to set up an escrow account for property taxes and your homeowner's insurance to go along with your mortgage.
They will divide your annual payment for these items by 12 and add that amount to your monthly mortgage payment. The funds are held by the lender until those payments become due. You might also pay mortgage insurance payments and homeowner's association dues into the escrow account.
Considering Loan Amortization
Your mortgage is set up so that the principal and interest portion of the payment is the same throughout the term of the loan. However, the amount that goes to interest and the amount that goes to principal changes over time. Mortgages are front-loaded, meaning most of the payment goes to interest in the early years and very little goes to principal. In later years, this reverses, with much more of your payment going to principal than interest.
For example, if your monthly principal and interest payment is $900, less than $100 may go toward paying down the principal during the first year if your loan has a 30-year term.
Changes to Escrow
On the other hand, your escrow payments may change frequently. If your house appreciates in value, your property taxes may increase when your house is reassessed for tax purposes, and your homeowner's insurance premiums may also rise over time. Escrow payments are adjusted annually.
If you paid too much in escrow during the year, your lender will either refund the money to you or lower your payment going forward. If you didn't pay enough, your lender may ask you to make a lump-sum payment or increase your monthly payments for the next year.