If you’re a homeowner, you probably know that a portion of what you pay the lender each month goes towards the original loan amount, while a portion is applied to interest. But understanding how banks actually allocate them can seem confusing.
You may also be wondering why your payment remains remarkably consistent even though your outstanding balance keeps dropping. If you understand the basic concept of how lenders calculate your payment, the process is easier than you might think.
Key points to remember
- Mortgage payments are made up of two parts. The principal is the loan amount itself and the interest is the monthly amount that the lender charges you in addition to the principal.
- With fixed rate mortgages, your monthly payment is consistent due to a process called amortization.
- In addition to the principal and interest you pay the lender, your monthly payment may also include other expenses such as mortgage insurance premiums and escrow taxes.
Principal and interest
Every mortgage payment you make is made up of two main components: principal and interest.
The principal is the initial amount of the loan. Suppose you buy a house for $ 350,000 and deposit $ 50,000 in cash. This means that you are borrowing $ 300,000 in principal from the lender, who of course wants you to pay that money back.
But the bank also charges a fee for lending you these funds, which is represented by the interest portion of your payment. Let’s say you pay off a 30-year mortgage with an annual interest rate of 4%.
Since you make monthly rather than annual payments throughout the year, this interest rate is divided by 12 and multiplied by the outstanding principal on your loan.
In this example, your first monthly payment would include $ 1,000 of interest ($ 300,000 x 0.04 annual interest rate Ã· 12 months).
How amortization works
Then you might be wondering why your mortgage payment, if you have a fixed rate loan, stays the same month to month. In theory, this interest rate is multiplied by a decreasing principal balance. So, shouldn’t your monthly bill go down over time?
The reason this isn’t is because lenders use amortization when calculating your payment, which is a way to keep your monthly bill consistent. The Mortgage Manager compensates for the fact that you pay higher interest charges in your early years by allowing you to make a lower payment on the principal.
If you plug your purchase price, down payment, loan term, and APR (see below under “Interest rate vs APR”) into the Investopedia mortgage calculator, you will see that your monthly payments to the lender would equal at $ 1,432.25. (You can also pay for things like mortgage insurance and property taxes held in escrow, although these don’t go to the actual lender.) As we noted earlier, $ 1,000 of your first installment strictly covers interest charges. This means that the remaining $ 432.25 pays off the outstanding balance or principal on your loan.
Assuming you don’t refinance, your loan payment will be the same 15 years later. But now you have reduced your main balance. You now owe about $ 193,000 of your loan principal. When you multiply that balance by your interest rate (0.04 12 months), you will find that the interest portion of your payment is now only $ 643.43. But you pay back a larger portion of your principal: $ 786.82.
Over the last few years of your mortgage, you pay even more principal off each month as your interest costs go down. By leveling your payments this way, lenders make your payments more manageable. If you’ve paid the same principal amount over the course of the loan, you’ll need to make much higher monthly payments right after you take out the loan, and then see those amounts drop when the repayment is complete.
If you’re wondering how much you’ll pay for principal versus interest over time, the Investopedia Mortgage Calculator also displays the breakdown of your payments over the term of your loan.
Variable rate mortgages
If you take out a fixed rate mortgage and pay only the amount owed, your total monthly payment will stay the same for the life of your loan. The portion of your payment allocated to interest will gradually decrease as more of your payment is allocated to principal. But the total amount you owe won’t change.
However, it doesn’t work that way for borrowers who take out an adjustable rate mortgage, or ARM. They pay a given interest rate during the initial period of the loan. But after a certain amount of time â say, a year or five years, depending on the loan â the mortgage âresetsâ to a new interest rate. Often times, the initial rate is set below the market rate at the time you borrow and then increases after the reset.
Suddenly you will notice that your monthly payment has changed. This is because your unpaid principal is multiplied by a different (usually higher) interest rate.
Interest rate vs APR
When you receive a loan offer, you may come across a term called an annual percentage rate, or APR. The APR and the actual interest rate the lender charges you are two separate things, so it’s important to understand the distinction.
Unlike the interest rate, the APR takes into account the total annual cost of underwriting the loan, including fees such as mortgage insurance, points of call, loan origination fees, and some closing costs. It averages the total cost of the loan over the life of the loan.
It’s important to understand that your monthly payment is based on your interest rate, not the annual percentage rate. However, lenders are required by law to disclose the APR on the loan estimate they provide after submitting an application, so that you can get a more accurate idea of ââhow much you are actually paying to borrow that money.
Some lenders may charge you a lower interest rate but charge a higher upfront fee. Therefore, the inclusion of the APR helps to provide a more comprehensive comparison of different loan offerings. Because the APR includes the associated fees, it is higher than the actual interest rate.
How is my interest payment calculated?
Lenders multiply your outstanding balance by your annual interest rate, but divide by 12 because you are making monthly payments. So if you owe $ 300,000 on your mortgage and your rate is 4%, you will initially owe $ 1,000 in interest per month ($ 300,000 x 0.04 Ã· 12). The remainder of your mortgage payment is applied to your principal.
What is depreciation?
The amortization of a mortgage loan allows borrowers to make fixed payments on their loan, even if their outstanding balance keeps falling. In the beginning, most of your monthly payment goes towards interest, with only a small percentage reducing your principal. When the repayment ends, that changes: more of your payment reduces your outstanding balance, and only a small percentage covers interest.
What is the difference between the interest rate and the APR?
The interest rate is the amount the lender actually charges you as a percentage of your loan amount. In contrast, the annual percentage rate, or APR, is one way to express the total cost of the loan. Therefore, the APR incorporates expenses such as loan origination fees and mortgage insurance. Some loans offer a relatively low interest rate, but have a higher APR due to other fees.
The bottom line
You probably know how much you are paying the mortgage agent each month. But understanding how this money is divided between principal and interest can seem a mystery. In fact, figuring out how much you’re paying in interest is as simple as multiplying your interest rate by your outstanding balance and dividing by 12. It’s only because lenders adjust the amount credited to your original loan balance that your payments stay remarkably consistent over the years.