Principal And Interest: Mortgage Payment Basics

Principal and interest are the two main components that make up every mortgage payment, but what is the difference between the two?

As you pay your mortgage, it’s helpful to understand how to calculate principal and interest and how much you’ll pay in both over the life of the loan. Keep in mind, too, that these aren’t the only components of your monthly payment.

What Is Your Principal Payment?

The principal is the amount of money you borrow with your home loan. To calculate your mortgage principal, simply subtract your down payment from your home’s final selling price.

For example, let’s say you buy a home for $300,000 and make a 20% down payment. In this instance, you’d put $60,000 down on your loan. Your mortgage lender would then cover the remaining amount by way of a loan for $240,000 – which is your principal balance.

As you begin making monthly mortgage payments and a designated amount of that payment goes to principal, your principal balance will begin to gradually fall. The amount you still owe in principal once you start making payments, and up until the end of your loan repayment term, is known as your remaining principal balance. Your repayment term is the number of years – usually 15 or 30 – that a borrower has to pay down their mortgage in full.

The Importance Of Principal

Your principal is the most important factor in deciding how much home you can afford. The principal you borrow immediately starts accumulating interest.

If you aren’t sure how much home you can afford, a good place to begin is with our mortgage calculator. Simply enter your purchase price, down payment and a few other pieces of information. The calculator will then give you a rough estimate of your monthly mortgage payment.

When deciding on a mortgage payment that’s in your comfort zone, don’t forget that you’re also responsible for maintenance, repairs, insurance and property taxes.

What Is Your Interest Payment?

The second major part of your monthly mortgage payment is interest. Interest is money you pay your mortgage lender in exchange for getting a loan. Most lenders calculate and determine your mortgage rate, or interest rate, as annual percentage rate (APR).

APR is the actual amount of interest you pay on your loan per year (APR includes your mortgage rate and fees/costs.). For example, if you borrow $100,000 at an APR of 5%, you’d pay $5,000 per year in interest. At the beginning of your loan (when your principal is highest), most of your monthly payment goes toward paying off interest.

How Is Your Interest Rate Determined?

The interest rate on your loan will depend on a number of factors, including market rates, which are largely influenced by the decisions of the Federal Reserve (the Fed). Your credit score, income, down payment and the location of your home can also influence how much you pay in interest. If you know your credit history isn’t that great, you may want to take some time to raise your credit score so you can save thousands of dollars in interest over time.

For example, let’s say your lender offers you $350,000 for a 30-year loan with 5% interest. Meanwhile the same lender offers someone with a lower credit score than you the same $350,000 for a 30-year loan, but with a 6% interest rate.

You’ll pay a total of $326,395 in interest by the time you make your last payment. The individual with the 6% interest rate will end up paying $405,434. In this example, just a 1% increase in interest rate means someone might pay over $79,000 more for their loan than someone with a 5% rate.

What Else Is Included In Your Monthly Payment?

Interest and principal make up the bulk of a mortgage payment, which also usually includes property taxes and homeowners insurance.

Lenders typically combine principal, interest, taxes and insurance (PITI) when determining how much house they’ll approve you for.

Property Taxes

No matter where you live, you’ll need to pay property taxes on your home. Taxes are often one of the most overlooked parts of owning a home, but they can also be one of the most expensive. Property taxes go to your local government and often fund initiatives in connection with public schools, roads, fire departments and libraries.

The amount you pay in property taxes will depend on the value of your home, the region you live in, and the local amenities your community offers. One reason you get an appraisal when you buy a home is so your local government can correctly calculate your taxes. Taxes can vary each year, and your county might require you to have your house appraised every few years.

Homeowners Insurance

You aren’t legally required to have homeowners insurance to own a home. However, most mortgage lenders won’t provide you a loan if you don’t have it.

Homeowners insurance protects you against damage from fires, break-ins and lightning storms, among other unfortunate occurrences. You may need an additional insurance policy to protect your home from damage caused by flooding and earthquakes.

Your homeowners insurance premium depends on a few factors, including:

• Home location
• Home value
• Whether you live in an urban or a rural area
• How close you are to a fire department or police station

While costs vary per state, the national average cost of homeowners insurance per year is around $2,500. Location, the home’s age and additional risk factors such as owning a pool can increase the annual total.

Escrow

Your mortgage lender might take a certain percentage of your monthly payment for an escrow account. An escrow account holds the money you owe in property taxes and insurance premiums. Lenders collect this amount and pay for it on your behalf to ensure you keep up with your coverage and tax dues.

The specific amount you’ll pay in escrow depends on your property tax rate and insurance costs. Your lender may reevaluate your escrow deposits whenever your taxes or insurance change.

Will My Principal Or Interest Ever Change?

Under most mortgage agreements, your mortgage payment will be the same amount each month until you pay off your loan (barring any changes in your property taxes and homeowners insurance premiums). However, your monthly payment will likely change if you choose an adjustable-rate mortgage (ARM). Similarly, the number of years you need to pay your mortgage may change if you pay ahead on your loan amount.

Adjustable-Rate Mortgage (ARM)

An ARM is a type of mortgage where your interest rate changes with market rates. Usually, you’ll enjoy a few years of low fixed interest rate with an ARM. When that introductory period ends, your rate will change based on market conditions.

If market rates go up, your rate goes up. If market rates go down, your interest rate will likewise go down. This can affect your monthly mortgage payment because your interest rate can fluctuate. The initial introductory rate on an ARM is lower than the rate with a standard fixed-rate mortgage, where your interest rate never changes for the life of the loan.

Paying Ahead On Your Loan

Although most of your monthly payment goes toward interest at the beginning of your loan repayment term, the amount you pay each month chips away at both the amount of interest you owe and your principal balance through a process called mortgage amortization.

Paying Ahead On Your Mortgage: An Example

Paying just a little extra money each month on your principal can save you a lot of money over your loan repayment term. And depending on how much extra you pay each month over a period of time, you may be able to pay your mortgage off in less time than your repayment term allows for.  

For example, let’s say you have a $350,000 loan with a 6% interest rate and a 30-year term. Your monthly mortgage payment would be $2,098, not including property taxes and homeowners insurance. Paying an extra $100 a month would reduce the amount of interest you pay over the course of your loan by nearly $54,694. You would also pay off your loan 3 years and 5 months earlier than you would if you made no extra payments.

The Bottom Line: Keep Track Of Your Interest And Principal

It’s important to be aware of the amount you’ll be paying in principal and interest each month – and over the life of the loan – if you plan to make only the minimum payment each month throughout the mortgage repayment term.

If you’re able to pay more than just the monthly minimum, it’s a good idea to do so. That’s because the sooner you can put a dent in your principal balance, the less you’ll pay in interest in both the short-term and long-term since interest is a percentage of the principal amount you still owe.