Most people think of the word “mortgage” as just a lump of money you give the bank to pay off your house. But it’s more than a lump. When you pay your monthly mortgage, that money goes toward the principal, interest, property taxes, insurance, and possibly PMI (private mortgage insurance).
What are those five things? We’re glad you asked, because we planned to tell you.
- Principal: The principal is the amount you borrowed to buy your house. So when you pay on the principal of your home, the amount you owe on the house goes down. Your goal is to get the principal down to zero—meaning you 100% own your home, mortgage-free.
- Interest: The interest is the money the lender is making. Paying this doesn’t lower the amount you borrowed, but it is the cost of borrowing.
- Property Tax: Most mortgages include your property tax in the monthly payment. The lender will set aside a portion of your payment in a separate “escrow” account and pay those taxes for you when they’re due.
- Insurance: The monthly mortgage payment can also include your homeowner’s insurance. Just like with the property taxes, the lender handles that payment for you.
- Private Mortgage Insurance: In the event of a foreclosure, the bank can often get around 80% of the home’s value. So if you don’t give them the other 20% up front as your down payment, they add on PMI to protect themselves.
All five of those things together shouldn’t be more than 25% of your take-home pay. When you start spending more than 25% here, you become “house poor,” meaning your house might be awesome, but the rest of your life suffers financially. Who wants to live in a three-story house with no furniture or a have a gourmet kitchen with no money to buy groceries?
Those may seem like extreme examples, but being house poor can put you at extreme risk later on.
Source: The True Cost of Owning a Home
