Principal vs. Escrow | Mortgage Loans Explained

Regardless of which type of payment you make on your mortgage, you know it’s a significant amount of money. Much more than a simple house payment, mortgages include taxes and fees that need to be considered.

If you have taken out a mortgage, you have likely seen terms like principal and escrow. But do you understand what these are? If you have any confusion over your mortgage, you’re not alone, and because of that, the finance experts here at Seek Capital are ready to help clear things up so that you have a firm grasp on the matter.

Line Items

In looking over your mortgage statement, you should see a breakdown of all of your charges. There should be several key items, including principal and escrow. Once you have identified your line items, read on to find out what each of them means.

Mortgage Principal

It’s important to understand that this is the amount of money owed that you borrowed on your home. As such, your mortgage principal does not include any interest. For that, you will need to locate the line item listed as “Interest.”

The reason that your principal mortgage doesn’t include interest is that interest continues to be collected all the way until closing. As you will discover in the “Interest” line below, you should plan on the total amount owed being greater than your principal balance.

Interest

Interest is the missing component to your mortgage principal that tells you the total amount that you will be paying back. Interest is the percentage that is charged to your loan balance. As such, it goes toward repayment to your mortgage lender.

With that being said, it’s important to remember that other charges and fees may be included in the total amount needed to pay off your loan. Late fees, insurance payments, deferred interest, and things of that nature may be present in the final amount owed.

Escrow Balance

Escrow has a very specific purpose. This is money that is put aside each month for a third party to use on your behalf in making payments toward your home insurance premiums and property taxes. Laws dictate that a lender is allowed to collect, at closing, 2 months’ worth of your estimated yearly insurance payments and property taxes.

After closing is completed, you will have to remit one month’s worth of the total annual amount along with every monthly payment toward your mortgage. The line item “Escrow” is the monthly amount that you owe. 

As per the RESPA (Real Estate Settlement Procedures Act), the minimum escrow balance that you should have ought to equal twice the amount of your monthly escrow payment. If your escrow balance drops below its recommended amount, your mortgage lender is likely to increase the mortgage payments that you are responsible for each month. 

Remember, your escrow account should be sufficient in covering your homeowner’s insurance and property taxes. If you’re short, you will have the option to pay a lump sum to recover your escrow balance. Moreover, it’s possible that you will get a refund on your escrow balance shortly after paying off your loan.

Estimated Escrow

This is essentially an approximation of your monthly property taxes and homeowners insurance. To determine your estimated escrow, check your Loan Estimate Guide and locate the section called “Projected Payments.”

What is Included in Escrow?

Your escrow account consists of additional charges and fees. You can find the terms of these charges and fees in your mortgage statement. Below, we will detail what your escrow account is made up of and how it appears on your statement.

Property Taxes

As a homeowner, you have to pay property taxes. One month’s worth of your annual property taxes is included in each of your monthly mortgage payments. This amount is usually kept in your escrow account.

Homeowners Insurance

Although it is usually listed as just “Insurance” on your mortgage statement, homeowners insurance protects you in the event that your home suffers damage, such as from a fire. To ensure that you are covered, your closing costs will include a year’s worth of homeowners insurance payments.

When you take out a mortgage, your lender will take a month’s worth of your annual mortgage payment each month to continue coverage with homeowners insurance. Most insurance companies that offer homeowners insurance are usually paid twice a year. This comes out of your escrow account.

Mortgage Insurance

Your mortgage insurance can vary depending on which program you chose in taking out a loan and the amount of your initial down payment. Mortgage insurance is necessary, as it protects your mortgage lender from losing out on their investment in the event that you default on your loan.

Your mortgage lender will need to get copies of your insurance and tax bills so they will know what to pay out of your escrow account. Never pay your insurance agent directly for things related to homeowners insurance, property taxes, or mortgage insurance.

Why Is Escrow Important?

Without escrow, you would be paying a significant amount of money all at once for your taxes and insurance. Escrow makes it possible to make smaller, manageable monthly payments. 

Most people who are buying a home, whether for the first time or otherwise, don’t have the finances available to pay off taxes and insurance all at once. The same is true for homeowners who are taking out a mortgage.

If you need to take out a mortgage, it is likely because you need money to pay for debt or other pressing expenses. The last thing you would want to do is use a large chunk of your finances to pay on your taxes and insurance.

Escrow avoids this potentiality and makes it easier to budget each month. It also makes taking out a mortgage much more manageable for many people. 

Principal Mortgage Payments

Unlike other types of loans, the principal on your mortgage is actually paid in arrears and after the interest on your mortgage has accrued. That’s why when you take out a mortgage, your first payment isn’t due until the first complete month following its closing.

For example, if you closed on your mortgage on the 17th of August, your first payment wouldn’t be due until October. With that being said, your mortgage lender is still going to collect the interest on those remaining days that are left in the month that you closed.

Using the example from above, that would mean that interest would be collected for 15 days, as it includes the day that you closed. This is done to ensure that all future payments remain the same. 

It is for this reason that many homeowners try to close on their mortgage nearer to the end of a month. Doing so means that there is less interest collected. 

Conversely, homeowners who need more time making their first payment would ideally close near the start of a month, as this would afford them more time to come up with the money needed to make their first payment. 

Just keep in mind that doing this will result in more interest being collected by the mortgage lender.

Tallying up What You Owe

Going through your mortgage statement and crunching numbers can be a convoluted and confusing venture. If you want to know the exact amount of what you owe, you should contact your mortgage lender

They can quickly and accurately tell you what you are responsible for paying. Moreover, you can ask your lender to send you a payoff quote so you will know what’s owed ahead of time. This helps some people to better prepare themselves financially for paying off their loan.

Just bear in mind that some lenders will charge you a fee for this service. What’s more, payoff quotes eventually expire due to the accumulating fees and charges. That’s why you should be prepared to pay off your loan shortly after requesting the quote.

If you wait too long, the amount that you owe will change and the quote will be rendered inaccurate. 

Summary

It is important for every homeowner to understand the intricacies of their mortgage. The better you understand it, the fewer surprises there will be along the way. Just remember that if you ever get confused about the payment structure associated with your mortgage to call your lender.

They can answer any questions you may have regarding your mortgage so that you’re up to speed. And if you need some advice and tips on other aspects, we encourage you to explore our many articles. Our dedicated team at Seek Capital has put together a collection of key information that is designed to make life a little easier. 

From getting help with small business loans to tips on real estate, you’ll find a wealth of support awaiting you!

 

Sources

https://www.consumerfinance.gov/ask-cfpb/what-is-a-mortgage-en-99/

https://www.wellsfargo.com/mortgage/manage-account/escrow/

https://loans.usnews.com/mortgage-lenders

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