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WalletPrep worksheet · Housing

How does a mortgage work?

Name ____________________ Date __________

Key ideas

  1. Each payment is principal plus interest. Interest is the balance times the monthly rate. Whatever is left of the payment pays down the loan.
  2. Most monthly payments also include escrow. Many lenders collect property tax and homeowners insurance with the payment and pay those bills for you from an escrow account.
  3. Compare offers with the Loan Estimate. Lenders must send this three-page form within three business days of your application. Every lender uses the same layout.

Vocabulary

Principal
The amount you borrowed, or the part of your balance that is still owed, not counting interest.
Amortization
Paying off a loan with equal payments over time, where early payments are mostly interest and later ones are mostly principal.
Adjustable-rate mortgage
A mortgage whose interest rate is fixed for a starting period, then changes on a schedule based on a market index plus a margin.
Private mortgage insurance
Insurance a lender usually requires on a conventional mortgage with less than 20% down. You pay for it, but it protects the lender if you stop paying.
Escrow account
An account your mortgage servicer uses to collect part of each payment and pay your property taxes and homeowners insurance for you.
Down payment
The cash you pay toward a home's price yourself at closing. A mortgage covers the rest.

Work it out

Lena borrows $270,000 for 30 years at a fixed 6.5% rate (an assumed rate; yours will vary). Her principal and interest payment is $1,706.58 a month.

  1. Loan amount
  2. Rate
  3. Monthly payment
  4. Interest, month 1
  5. Principal, month 1
  6. Paid over 360 months
  7. Amount borrowed
  8. Total interest

Check yourself

  1. Your balance is $200,000 at 6% a year. How much interest is charged this month?

    • A. $12,000
    • B. $600
    • C. $1,200
    • D. $1,000

  2. Why does more of each payment go to principal over time?

    • A. The lender lowers your rate every year
    • B. Interest is charged on a balance that keeps shrinking
    • C. The payment gets bigger each year

  3. When must a lender give you a Loan Estimate?

    • A. Within three business days of your application
    • B. At closing
    • C. Only if you ask in writing
    • D. After you sign the purchase contract

Your turn

Open the CFPB's Explore Interest Rates tool and enter your state, credit score range and a down payment. Then put that rate into the mortgage calculator to see your payment and how much of it is interest.

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Answer key

How does a mortgage work?

Work it out

  1. Loan amount$270,000
  2. Rate6.5% fixed, 30 years
  3. Monthly payment$1,706.58
  4. Interest, month 1− $1,462.50
  5. Principal, month 1= $244.08
  6. Paid over 360 months$614,370
  7. Amount borrowed− $270,000
  8. Total interest= $344,370
  1. Month 1 interest: $270,000 × 6.5% ÷ 12 = $1,462.50. The rest, $1,706.58 − $1,462.50 = $244.08, pays down the balance.
  2. Over 360 payments Lena pays about $614,370 in total. Minus the $270,000 she borrowed, that is $344,370 in interest.
  3. At the same rate over 15 years, the payment is $2,351.99 and total interest falls to $153,358.

Check yourself

  1. D. $1,000 $200,000 × 6% ÷ 12 = $1,000. Interest each month is the balance times the yearly rate divided by 12.
  2. B. Interest is charged on a balance that keeps shrinking With a fixed payment, a smaller balance means less interest, so more of the same payment goes to principal.
  3. A. Within three business days of your application Lenders must provide a Loan Estimate within three business days of receiving your application, on a standard form that makes offers easy to compare.