This might seem like an odd question. You take out a loan to pay for a house, then repay the loan in monthly installments over a long period of time. If you sell before the mortgage term is over, you pay the remaining balance after the sale. While that is the gist of it, it’s possible to know what something is without knowing how it works. Knowing you have to pay every month is useful information, but it doesn’t tell the whole story.
Principal is just the word used to mean the amount of money you borrowed. When you buy a house for $400,000, with a 20% down payment, your mortgage will be $320,000 – that’s the principal.
The principal is one half of the mortgage; the other half is interest. Lenders charge a certain percentage of the loan’s value in interest when you take a loan. Right now, the lowest rate for a 5 year variable mortgage is 2.43% APR – but depending on your credit score, you could be paying interest rates all the way up to 18%. Obviously, lower is better.
How Interest Is Calculated
Since interest is a percentage based on the loan’s value, the exact number depends on the size of your mortgage. Continuing our $320,000 mortgage, let’s look at our first monthly payment. If you’re only interested in the numbers for your mortgage specifically, you can use this mortgage payment calculator to tell you exactly what you’ll be paying per month. If you’re interested in how we get that number, read on.
Here are all the numbers for this mortgage:
· Amount borrowed: $320,000
· Interest Rate: 2.99%
· Amortization: 25 years
· Payment schedule: Monthly
With this info, we can calculate our monthly payments.
Here’s the very scary looking equation:
P = L[c(1 + c)]/[(1 + c) - 1]
· P = monthly payments
· L = loan value
· N = months
· C = monthly interest rate
And here it is with all the numbers:
P = $320,000[0.00249(1 + 0.00249)300] / [(1 + 0.00249)300 – 1]
1680.21 ÷ 1.11 = $1515.48
We’ll round this up to an even $1516 (your lender probably will, too).
You can also use this number to calculate the total cost of the mortgage by multiplying it by the amount of months the mortgage will last. A 25 year mortgage lasts 300 months, so the total cost of this mortgage is $454,643.91 (1515.48 × 300).
Interest vs. Principal
Great, now we know what the monthly payment will be, and how much it will cost – but how much goes towards interest, and how much towards principal?
Mortgage payments put more money towards interest at first, but as you keep paying, the amount of interest you pay decreases. The first month of this mortgage costs $797 in interest – the last month costs $4. This is because the amount of interest you pay is based on the remaining principal. At the start of this mortgage, the balance is $320,000, but during the last month the remaining principal is just $1512.
For a balance of $320,000, the monthly interest payment is calculated like this:
Monthly interest payment = L × c
Remember, monthly interest rate is calculated as the annual percentage (as a decimal) divided by the 12 months in a year.
$320,000 × (0.0299 / 12) = $797
We already know that our monthly mortgage payment is $1516, so that means the amount of money that goes towards the principal is $719 ($1516 - $797).
Next month, the remaining principal is no longer $320,000, but neither is it $318,484 ($320,000 - $1516); instead, it’s $319,281 ($320,000 -$719). The next month’s interest rate is calculated with this new principal, so the interest is:
$319,281 × (0.0299 / 12) = $796
Just a one dollar difference?! Unfortunately, yes. Because the amortization is so long, and the monthly payments are so low in comparison to the value of the loan, the difference between months is very small. You’re looking at an average of $2 less paid towards interest every month. At most, the gap is still only $4. But remember, there’s 300 months in this mortgage. After 10 years, the interest paid will already be down to $547 – a 31% decrease.
Because you pay more money in interest at the start of a mortgage rather than the end, if you are able to aggressively use your pre-payment or lump-sum options (if your mortgage term allows it) to quickly bring down the principal at the start, you can save thousands of dollars by avoiding interest.
For the first year of this mortgage, you’d pay $10,224 in interest and $9481 towards the principal. If you pay a lump-sum of $9481, you’d skip that $10,224 in interest. If you made that same payment towards the end of your mortgage, you’d only save $79!