Simply put, your mortgage principal is the amount you owe the lender (or bank, or credit union).
Your mortgage principal starts out at whatever amount you have to borrow in order to pay the full price of your house.
Your principal decreases every time you make a mortgage payment. It’s important to note that, as you pay down the principal, you are building “Equity” (ownership) in your home.
What is Equity
Equity is the dollar amount of ownership you have in your home. For example, if an appraisal on your home sets its value at $200,000, but you only owe the bank $150,000, you have $50,000 of equity in your home. So, your principal is equal to the purchase price of your home, right?
Not always. Buyers often must borrow additional funds in order to pay “closing costs”.
For example, if the purchase price of your dream home is $200,000, chances are you do not have enough money in your savings to pay cash for it. You’ve scraped enough money together for a 5% down payment ($10,000) and that’s it. So you do what any other red-blooded American would do. You borrow the money from a bank or other lending institution.
Well, setting up a home loan involves a variety of costly tasks:
• The lender will do a title search to make sure that the seller actually owns the house they are selling to you—kind of important ; )
• The lender will order an appraisal to be done on the property.
• The closing attorney will charge a fee for overseeing the transaction.
• You will pay an application fee to the lender.
• The loan officer will charge an origination fee.
• You will pay interest for the remaining days in the month after the closing date. (This is called pre-paid interest). That’s why it is best to close as late in the month as possible. If you close on the last day of the month, you will only be charged one day of pre-paid interest. This expense is included in your closing costs as a “pre-paid item”. There are other pre-paid items that will be discussed later.
• You will have to start a reserve fund with the lender to cover your annual property taxes and home owner’s insurance.The above list represents only a few of the tasks and fees involved in setting up a home mortgage. The bank/lender will charge what they call “closing costs” in order to cover the expenses involved in accomplishing all these tasks and then add a little more on top to insure that they make money in the process—it’s the American way, right? Ok, so your house costs $200,000, but your closing costs will probably run another $6000 or so.
Most folks do not have $6000 in spare change sitting in a savings account, so the lender will usually allow the borrower to add his closing costs onto the mortgage amount. Continuing with our example, the price of the house is $200,000, but you have to cover the purchase of the house plus the closing costs. Your principal – the amount you owe the bank — is $206,000, right? Nope.
Don’t forget to reduce that amount by your down payment, $10,000. You will need to actually borrow $196,000, and that is your principal—the amount you owe the lender.
The good thing about principal is that it goes down every time you make a mortgage payment—that is, unless you have an interest only mortgage.
With an interest only mortgage, your mortgage principal never decreases, because, hello, you’re paying “interest only”—no principal—the amount you owe the bank never goes down.
Ok, enough about interest only loans. This section is about mortgage principal, and I have explained it pretty thoroughly—principal is the amount you owe the lender.