How mortgage interest works can be confusing because banks structure home loans to have monthly payments where the principal decreases consistently over time. Most of the time the payments are fixed, but they do offer options where the interest portion adjusts while the principal payment remains fixed. In this article we:
- Explain how interest is calculated
- Give examples of the four common types of mortgages
- Explain the mortgage interest formula
- List some good mortgage calculators
Mortgage interest works slightly differently depending on the type of loan you have, but the main difference between different loan instruments is whether you get a fixed or adjustable interest rate.
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How is Interest Calculated on a Mortgage?
Mortgage interest is calculated according to a process call amortization. It is easiest to see how it works for the case of a fixed-rate loan. The most common is a 30-year term with a monthly payment. In this case:
- Monthly payments toward the loan are the same for the life of the loan.
- At the beginning of the loan, you pay much more for interest and over time it transitions to more applied to the principle.
At the end of each month, interest is applied to the outstanding principal. You make your monthly payment. Next month, the interest is applied again to the principal. This continues over time until you pay off your loan. In the beginning, the loan is very large so interest takes up almost all the payment. In the end, however, the loan amount is small, so interest only makes up a small percentage of your payment.
How Often is Interest Compounded on a Mortgage?
Interest is compounded with each payment. Most of the time banks require monthly payments. With each new payment, they calculate the interest amount and add it to the principal. Then, next month they do it again. This happens each month until the loan is paid off.
Do You Pay More Interest at the Beginning of a Mortgage?
You do pay more interest at the beginning of a mortgage. Since the banks keep payments the same, almost all your early payments go toward interest. As you pay off more of the principal, the percentage of your monthly payment that goes toward interest reduces.
Why is My Mortgage Interest Different Every Month?
As you progress through the process of paying off your loan, you should see the interest payments reduce over time. Likewise, you should see the amount of your payment goes toward the principal increase. This is caused by the fixed monthly payments. As you pay off the loan, the principal balance goes down, and therefore interest amount (not rate) reduces.
Once you understand this, it can be a powerful tool you can use to pay off your loan much faster and save a lot of money. During the beginning periods, most of your payment goes toward interest. Very little reduces the principal. If you can pay a little more money each month, or add a payment regularly toward the principal then it resets the balance between interest and principal. Even a small amount extra put toward you principal in the beginning months can have a big impact on the amount of total interest you pay and the length of your loan.
How Much Difference Does 1 Percent Make on a Mortgage?
One percent makes a big difference on any mortgage, but the bigger the loan the more difference it makes. For instance, if you take out a 30-year fixed-rate mortgage for $200,000 at 4% your monthly payment will be $955. At 5% that grows to $1,1994. That difference is $239 per month, or after 30 years $35,935.
For $400,000 the amount is even more. At a 4% interest rate, the monthly payment is $1,910. At 5% that payment jumps to $2,387. That difference is $477 per month or $71,870 for the life of the loan. As you can see these differences are substantial, so it is in your best interest to make sure you get the best interest rate possible.1
Example of How Mortgage Interest Works
Banks calculate mortgage interest based on the principal owed at the end of each payment period, and they calculate a monthly payment by multiplying the interest rate to the balance. They then add that amount to the balance to arrive at the next month’s payment. While this is true for all mortgages, there are different types of home loans. Therefore, there are subtle differences for each of these types of mortgages.2
Fixed-Rate Mortgages
The example we used earlier is a fixed-rate mortgage. You make a fixed monthly payment over a fixed number of years. The bank compounds the interest each month, but they provide you with a chart of how much each payment will go to pay interest charges and the principal balance.
If you plan to stay in your house for a long time, this is the best option. Further, if you can add a little to your payments early on you can significantly reduce your total interest payments and shorten the life of the loan. Another way is to pay bi-weekly. This adds two payments each year, but it has a huge impact on the duration of your mortgage.
Adjustable-Rate Mortgages (ARMs)
As the name implies, ARMs’ interest rates adjust, but the payoff period does not. This means that your payments may change as the interest rate adjusts. Most ARMs have limits, or caps, on how:
- High the interest can go up
- Much the interest rate can fluctuate
- Often the rate can change
Lenders often offer a lower rate for the first few years. After that, the interest usually adjusts about once per year. Most of the time it goes up. The adjustments are typically tied to indexes, such a treasury bill indexes, with a margin. The margin reflects the risk the bank takes for underwriting the loan.
With ARMs you should be very clear about how often the rate adjusts. A typical ARM is 5-1. That means for the first five years the interest rate is fixed, but after that, the rate adjusts once every year. For a $200,000 loan at 4% under these terms, the first 60 payments would be $955 per month. For the next 12 months, the rate may rise by 0.25%. This means the next 12 payments would be $980. After 12 more months, the rate may rise again another 0.25% making the new monthly payment $1,005.
Interest-Only Loans
These loans are not as common as the first two. Under the terms of these mortgages, you pay only the interest for the first few years, and then you pay off the balance in a specified period. These instruments feature:
- Interest only payments for the first few years, not the entire life of the loan
- Lower payments in the beginning, but much larger payments later
Banks targe these loans for wealthy buyers or people with irregular incomes. Most people who get these loans sell before the interest-only payment period expires. If you get one of these the most important thing to remember is that you will not build equity in the property. Therefore, if you cannot sell it for the amount you owe you must pay the difference out of pocket.
Jumbo Mortgages
Jumbo loans are also called non-conforming loans. Fannie Mae and Freddie Mac insure mortgages for banks, and they also buy loans and repackage them for the secondary market. The only insure and buy loans that meet their criteria. These criteria include the:
- Amount of the loan
- Credit worthiness of the borrower
If the loan meets these criteria it conforms to Freddie Mac’s and Annie Mae’s rules. If it does not, then it is a non-conforming loan. These loans are riskier for the banks, and they charge higher interest rates and insist on stricter terms. Most jumbo loans are for very expensive houses.
Mortgage Interest Formula
What is the formula that banks use to calculate your monthly payments? Here it is:
P = L[c(1 + c)n]/[(1 + c)n – 1]
This may look a little confusing, but all you must do is plug in the variables, so let’s look at what they are. Then, you will be able to figure out for yourself what your mortgage payment should be for a fixed-rate mortgage.
- P – The fixed monthly payment: this is what we are looking for
- L – Your loan amount (how much you owe)
- c– Monthly interest rate (Calculate this by taking your APR and dividing it by 12; If your bank quotes you a 6% interest rate, then c is .06/12 = .005)
- n– the number of months to pay off the loan (for a 30-year loan n = 360)
Now suppose you want to know the balance you still owe after a while. Maybe you just want to check up on your bank or maybe you made extra payments. Here is the formula to find your balance at any point:
B = L[(1 + c)n – (1 + c)p]/[(1 + c)n – 1]
In this case, you do not find P. Instead, you find B, which is your loan balance at any specific time. That means you need to already know your monthly payment before you use this formula. All the other variables are the same as above.3
Mortgage Interest Calculator
If looking at mathematical formulas gives you a headache or you just do not want to trust your skills, you can always use a mortgage calculator. Almost any lender has one on its website. Also, here are a few that I think are good. Just click on one of the following links:
Final Thoughts on How Mortgage Interest Works
How mortgage interest works may seem very confusing, but banks use this type of loan for a reason. It provides stable, affordable monthly payments for a very big loan paid over many years. The advantage for banks is it reduces risk. The advantage for homebuyers is they can afford a house by putting a reasonable amount down and then having affordable monthly payments.
Now that you know how mortgage interest works you can see the advantage to making additional payments to the principal early in the life of the loan. Sometimes you can save thousands of dollars from interest payments and shorten the life of the loan by months and even years.
