When you take out a mortgage to buy a home, you're asking a lender to let you tie up a large amount of its money for up to 30 years. You're going to have to pay for that privilege in the form of interest. And you're going to pay that interest for as long as you're using any of the lender's money.
How It Works
In most cases, you pay your mortgage on a monthly basis, and a portion of each payment consists of the interest that has accrued on the outstanding balance of your loan over the previous month. The monthly interest rate is simply the annual interest rate divided by 12. So say you take out a 30-year mortgage for $200,000 at 6 percent annual interest. Each month, you'll pay 0.5 percent interest on the outstanding mortgage balance. Your first payment, then, will include $1,000 in interest -- 0.5 percent of $200,000.
Of course, your mortgage payment doesn't just consist of interest. If it did, you'd never get the loan paid off. Each month, you'll also pay off some of the principal -- the money you actually borrowed. Lenders use a mathematical formula, called an amortization formula, to set your payment so that the total combined amount you pay in interest and principal is the same each month, which helps immeasurably with financial planning. For the loan in the previous example, the formula produces a monthly payment of $1,199.10. If your first payment included $1,000 in interest, then the principal portion is $199.10.
As you start repaying your loan, you're paying far more in interest than in principal. This is standard. Interest is the bank's profit -- the cost you pay for the loan -- and the bank will get a large portion of its profit early, before you start building significant equity by paying down the principal. Eventually, though, you do start gaining equity. Since your principal balance gets smaller each month, your monthly interest charge will get a little smaller, too. Your monthly payment remains the same -- so you'll pay off a little more of the principal each month. The second $1,199.10 payment in the previous loan example consists of $999 in interest and $200.10 in principal. The 120th payment -- that is, after 10 years' worth of payments -- includes $838.66 in interest and $362.44 of principal. After 20 years, it's $543.31 in interest and $655.79 in principal. Your interest rate determines the point at which the proportion flips and you start paying more in principal than in interest. The lower the rate, the sooner the flip. At 6 percent interest, that occurs after 222 payments, or 18 years, six months.
When It Ends
Though interest represents a smaller share of each successive payment, you're still going to pay interest for as long as you have an outstanding mortgage balance. In other words, if you take out a 30-year mortgage and make payments for the full 30 years, you'll pay interest for the full 30 years, too.
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