If your head spins and your vision goes blurry when faced with complicated math problems, don’t worry. You only need to have a very slight understanding of mortgage amortization and a basic knowledge of the concept behind principal and interest to enter into your next mortgage as an educated consumer.
When you sign on for a mortgage, your lender sets up a repayment schedule according to the terms you previously agreed upon. Lenders use a method called amortization to determine the total payment amount and how it will be allocated. With most mortgages, each payment you make reduces the original loan balance. After each payment, the lender recalculates the loan based on the new loan balance to determine how to allocate the next payment. Although the total payment does not change unless you have an adjustable-rate mortgage, or ARM, the way the lender allocates the money does change after each payment.
Principal is another term for the amount of money that you originally borrowed less any amounts you have repaid. With traditional mortgages, you reduce the principal amount each time you make a payment. During the early years of a mortgage, the lender applies very little towards the principal with each payment. Over time, the amount applied towards principal each month grows as you reduce the principal balance. You can usually speed the process along, thereby decreasing the length of your mortgage and reducing interest paid, by making additional payments towards the loan’s balance.
Banks and financial institutions don’t lend money out of the goodness of their hearts. They charge a certain amount of money, or interest, for the privilege. Lenders express the rate of interest as a percentage of the amount of outstanding principal. To determine the amount of each payment that the lender will allocate towards interest, divide the interest rate by the number of payments you make each year, and multiply that times the outstanding principal. If you owe $100,000 on your mortgage at an interest rate of 6 percent and you make monthly payments, divide 6 by 12, giving you 0.5 percent, and multiply that times $100,000, or $500.
Exceptions to the Rule
Although the concept behind principal and interest does not change, a few types of mortgages do not adhere to the traditional rule of principal and interest payments. Interest-only mortgages, for instance, allow you to pay only the interest you accrue for the first several years of your mortgage with no monies applied towards the principal. Lenders sometimes offer minimum or limited payments on option ARMs. In this case, the loan works like an interest-only loan, but the lender only obligates you to pay a portion of the interest you accrue at each payment. Bloomberg BusinessWeek calls these “nightmare mortgages,” because the unpaid interest is added to your original loan balance, making your principal grow over time instead of decrease.