Explanation of a Mortgage Interest Payment

If you've got a mortgage, you've got interest. It's as common as apple pie and vanilla ice cream. Only in utopia will a bank give you credit for nothing. When you're examining your good-faith estimate and other mortgage paperwork, make sure you have a complete understanding of the interest payments you'll be making to your lender each month.

Mortgage Interest

In short, mortgage interest is the cost you pay to the bank for the benefit of using the lender's money to buy your home. The bank charges you regular equal monthly installments that include both the interest cost for each month and a principal payment. The interest cost varies every month and is most expensive at the start of the loan.

How It is Calculated

The calculation for interest on a mortgage loan is fairly straightforward. You multiply the monthly interest rate by the current balance. So if your yearly interest rate is 5 percent, your monthly interest rate is about .4167 percent or 0.004167. If you borrowed $180,000 to purchase your home, the initial interest payment due is $180,000 times .004167 or $750.06. The rest of the payment ($216.22 in this example for a 30-year loan, which has a payment of $966.28) goes to principal.

Understanding Amortization

As a home loan amortizes (a fancy word for the reduction of the balance over time) the amount of interest you pay declines each month. This is because the balance also goes down every month. So in the example above, the first month's interest is based on $180,000, while the second month's interest charge is based on a balance of $179,783.78 ($180,000 less $216.22). Eventually, the amount of interest you pay each month will be lower than the amount of principal paid until it completely disappears and the loan ends.

Interest-Only Mortgage

Though not as common as traditional fixed-rate or adjustable-rate mortgages, interest-only home loans are offered by some lenders. As the name suggests, in this scenario the borrower's payment is composed only of the interest cost for a period of time. It's beneficial to someone who does not plan to keep the home for long, like a real estate investor. The downside is that you're not making any progress with paying off the balance until you finally make your first principal payment.

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