If you buy a home with financing, you will have to pay interest on your mortgage. These fees pay the bank for loaning the money in the first place and allow the bank to make more loans. If you want to know how much interest you pay each year, you need to understand how interest works on these complex loans.
Know the Parts of a Mortgage
Before you can understand how interest works on mortgages, you need to know what goes into your mortgage payments. First is a payment toward the principal of your mortgage.
The principal is the amount you owe on the loan. For example, if you took out $200,000 for your home, that is the principal balance the first month. Each month, it gets smaller.
The second piece of your mortgage payment is the interest. This is the fee that the bank charges to loan you the money. When you bought the house, the lender expressed this in a percentage. The lower the risk of lending to you, the lower the rate is.
If your down payment was less than 20 percent of the cost of the home, you likely have Private Mortgage Insurance (PMI) in your payments. This gives banks the incentive and low-risk necessary to lend in these situations.
Finally, you have your escrow account. In many cases, this includes the estimated property taxes and home insurance payments for the year. At the end of the year, the lender collects all the money in the escrow account and pays these fees for you.
Understanding Amortization Loans
Auto, home and personal loans often go through a process called amortization. With a mortgage, you pay the same amount each time. However, the percentages that go toward your principal and interest change each time you make a payment. Since most homeowners make monthly payments, the percentages adjust 12 times per year.
This happens because the bank charges interest based on the monthly principal. So if you owe $200,000 in the first month and $199,800 the next month, the interest will be slightly different in each of these payments. The lenders use amortization charts to calculate each month for the life of a loan to keep your payments even.
Calculate Your Per Annum Interest
If you want to see how much interest you pay throughout the year on your mortgage, you should start with the first month. In this example, you borrowed $100,000 at a 6.25 interest rate and make monthly payments.
To calculate your per annum interest, first, multiple your loan amount by the interest rate. For the example, this would be 0.0625 multiplied by $100,000. Then, divide the annual interest amount by 12. In the first month, $520.83 goes toward interest. Write down this figure to the side.
Discover how much the principal balance will be the next month. If your payment is $1,400 per month, you take that amount and subtract $520.83. Then, subtract the insurance, PMI and taxes. These stay the same for each month, at least for one year. For this example, say that's $500 each month.
You then have $379.17 left in your payment for the first month. All of this goes toward the principal. After the first payment, your principal balance is $99,620.83. Make the same calculations for the second month using this new balance. Write the interest from the second month next to the first one.
Repeat the full process for each of the 12 months. Then, you can add the interest totals from all the months. At that point, you will know exactly how much you give the bank in interest that year.
Although it's great to know how amortization works, calculators can help you learn about your loan quicker than doing it by hand. Check out an interest calculator from your financial institution or another trusted source.
- Your actual annual percentage rate, or APR, may differ from your per annum interest rate because your APR takes into account additional fees your bank may charge. In this way, mortgages with high interest rates and low fees may be less costly than mortgages with low interest rates and high fees. Ask your bank for your mortgage's APR, or look at your statement to determine the fees that effectively increase your interest rate.
- Use a mortgage interest calculator (see Resources) to make the calculations automatically, or calculate your mortgage payments over a longer period of time.
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