Excluding
property taxes and insurance, a traditional fixed-rate
mortgage payment consist of two parts: (1) interest
on the loan and (2) payment towards the principal,
or unpaid balance of the loan.
Many
people are surprised to learn, however, that the amount
you pay towards interest and principal varies dramatically
over time. This is because mortgage loans work in
such a way that the early payments are primarily in
interest, and the later payments are primarily towards
the principal.
In
the beginning. you pay interest
To help calculate monthly payments for loans based
on different interest rates, lenders long ago developed
what are known as "amortization tables."
These tables also make it fairly easy to calculate
how much money of each payment is interest, and how
much goes towards the principal balance.
For
example, let's calculate the principle and interest
for the very first monthly payment of a 30-year, $100,000
mortgage loan at 7.5 percent interest. According to
the amortization tables, the monthly payment on this
loan is fixed at $699.21.
The
first step is to calculate the annual interest by
multiplying $100,000 x .075 (7.5 %). This equals $7,500,
which we then divide by 12 (for the number of months
in a year), which equals $625.
If
you subtract $625 from the monthly payment of $699.21,
we see that:
- $625
of the first payment is interest
- $74.21
of the first payment goes towards the principal
Next,
if we subtract $74.21 (the first principal payment)
from the $100,000 of the loan, we come up with a new
unpaid principal balance of $99,925.79. To determine
the next month's principal and interest payments,
we just repeat the steps already described.
Thus,
we now multiply the new principal balance (99,925.79)
times the interest rate (7.5%) to get an annual interest
payment of $7,494.43. Divided by 12, this equals $624.54.
So during the second month's payment:
- $624.54
is interest
- $74.67
goes towards the principal.
Note:
In Canada, payments are compounded semi-annually instead
of monthly.
Equity
As you can see from the above example, even though
you pay a lot of interest up front, you're also slowly
paying down the overall debt. This is known as building
equity. Thus, even if you sell a house before the
loan is paid in full, you only have to pay off the
unpaid principal balance--the difference between the
sales price and the unpaid principle is your equity.
In
order to build equity faster--as well as save money
on interest payments--some homeowners choose loans
with faster repayment schedules (such as a 15-year
loan).
Time
versus savings
To help illustrate how this works, consider our previous
example of a $100,000 loan at 7.5 percent interest.
The monthly payment is around $700, which over 30
years adds up to $252,000. In other words, over the
life of the loan you would pay $152,000 just in interest.
With
the aggressive repayment schedule of a 15-year loan,
however, the monthly payment jumps to $927-for a total
of $166,860 over the life of the loan. Obviously,
the monthly payments are more than they would be for
a 30-year mortgage, but over the life of the loan
you would save more than $85,000 in interest.
Bear
in mind that shorter term loans are not the right
answer for everyone, so make sure to ask your lender
or real estate agent about what loan makes the best
sense for your individual situation.
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