Each month you make payments on your new mortgage, a portion of the payment goes to paying down your balance, or principal, while the other portion pays your interest charge. The proportion of your payment that pays interest versus principal changes every month. Even though you can find a wide variety of different online mortgage calculators that will perform the calculation for you, it's smart to learn exactly how the interest is calculated.
What Is Mortgage Amortization?
When you establish a mortgage account, the lender determines your interest costs based on an amortization schedule. Amortization is simply a method of reducing an installment loan debt until it reaches zero. It takes into account both payments toward the loan balance and payments of interest. An amortization table lists the amount of interest and principal paid every month over the life of the loan, as well as the principal and interest totals paid to date, in a convenient and simple-to-follow format.
Information Needed for Calculation
In order to calculate the interest expense for a mortgage, you need to know several key details.
First, you need to know the term of the mortgage; most are for 30 years, but other terms are available. Then you need the mortgage principal, which is the amount you financed. Next, you need to know the interest rate on the loan, which will remain the same throughout the term if you have a fixed-rate mortgage. Finally, you must know your monthly payment on the mortgage so that you can determine what portion of each payment is going to pay principal versus interest for each month of the loan.
How to Calculate Mortgage Interest
The way the mortgage company calculates your interest is pretty straightforward. You can do this by multiplying the balance by the monthly interest rate. So, for instance, if your interest rate on a $100,000 30-year loan is 7 percent, the monthly interest rate is 0.58333 percent, which you get by dividing the yearly interest rate by 12; 7 divided by 12 is .58333 percent or .0058333.
When you multiply that monthly rate by the initial balance of $100,000, it results in the first month's interest cost of $583.33. Your monthly payment on this hypothetical loan is $665.30, so this means that the principal paid down that month is $81.97: the payment of $665.30 minus the interest payment of $583.33. Deduct the principal from the previous balance – $100,000 minus $81.97 – to get the loan's new balance of $99,918.03 for the next month. Then repeat this process to determine the interest cost for the next month and each subsequent month thereafter.
Less Interest with Time
As you continue to calculate interest for the mortgage in this way, you'll notice that the amount of interest you pay each month goes down as the amount of the loan balance you pay each month goes up. Eventually, the portion of your monthly mortgage payment that goes toward principal will exceed the amount going to interest until the balance of your loan is paid off.