How Does Mortgage Interest Work?

Early on, your mortgage payments are mostly interest.

Early on, your mortgage payments are mostly interest.

Since not a lot of people have hundreds of thousands of dollars stuffed in a shoebox under the mattress, most folks who want to buy a home must borrow money to do it. That means taking out a mortgage, which means paying interest to a lender. The way most mortgage loans are structured, your monthly payments in the beginning are mostly used to pay off interest rather than principal on the loan. It isn't until later in the payment cycle that you begin to build up significant equity in the home.

Monthly Rate

The interest rate on your mortgage is an annual rate, but it's applied on a monthly basis. To get the monthly rate, divide the annual rate by 12. For example, if you have a mortgage with a 6 percent annual rate, the monthly rate is 0.5 percent. If the annual rate is 4.5 percent, the monthly rate is 0.375 percent, and so on.

First Monthly Payment

Your monthly mortgage payment includes the interest due that month and a portion of the principal, or the money you borrowed to buy the home. Each month, your interest charge is the monthly rate multiplied by the outstanding principal balance. Say you just took out a 30-year mortgage for $100,000 at an annual interest rate of 4.5 percent, which is 0.375 percent a month. Your interest charge that first month is $375, or 0.375 percent of $100,000. You'll also pay off a bit of the principal. Lenders use a formula to set up your payments so that the interest and the principal added together come out to the same amount each month, which really helps with financial planning. On this loan, that monthly amount is $506.69, so your first month's payment will include $131.69 toward the principal, and your principal balance drops to $99,868.31

All the Rest of the Payments

Since your principal balance gets smaller with each payment, so does your interest charge. On the loan in the example, the second month's interest charge is 0.375 percent of $99,868.31, or $374.51. The principal portion of your payment rises to $132.18, for a total payment of $506.69. With each successive payment, you pay a little less interest and a little more principal. If you stay in the house for the full 30 years, your last payments will be almost all principal, with very little interest.

Adjustable-Rate Mortgages

The previous example dealt with fixed-rate mortgages, in which the interest rate remains the same for the whole term of the loan. Banks also offer adjustable-rate mortgages, in which the rate bounces up and down based on what interest rates are up to in the world at large. When it comes to your monthly payment, adjustable-rate mortgages work pretty much like the fixed-rate version. The only difference is that when the interest rate adjusts, the lender recalculates your monthly payment based on the new rate, the time left on your loan, and your current outstanding principal balance. The adjustments take place on a set schedule -- say, once a year or every two years.

In the End

Depending on the rate, you could wind up paying more in interest than you borrowed in the first place. On a 30-year loan for $100,000 at 4.5 percent, for example, you'd pay a total of about $82,400 in interest -- on top of the $100,000 principal you'll repay. But at a 6 percent annual rate, the total interest would be nearly $116,000. A percentage point or two makes an enormous difference in the long run.

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