Why Do Most of My Mortgage Payments Start Out as Interest?

When you make a mortgage payment, the amount paid is a combination of an interest charge and principal repayment. Over the life of the mortgage, the portions of interest to principal will change.

At first, your payment will be primarily interest, with a small amount of principal included. As the mortgage matures, the principal portion of the payment will increase, and the interest portion will decrease. This is due to the interest charge being calculated off the present outstanding balance of the mortgage, which decreases as more principal is repaid. The smaller the mortgage principal, the less interest is charged.

For example, let's examine a simple mortgage for $100,000 at an interest rate of 4% annually and a time to maturity of 24 years. The yearly mortgage payment is $6,558.68. The first payment will consist of an interest charge of $4,000 ($100,000 x 4%) and a principal repayment of $2,558.68 ($6,558.68 - $4,000). The outstanding mortgage balance after this payment is $97,441.32 ($100,000 - $2,558.68). The next payment is equal to the first, $6,558.68, but will now have a different proportion of interest to principal. The interest charge for the second payment equals $3,897.65 ($97,441.32 x 4%), while the principal prepayment is $2,661.03 ($6,558.68 - $3,897.65).

The principal portion of the second payment is about $100 larger than the first. This occurs because you've paid money towards the principal amount — lessening it —and the new interest payment is calculated on the lower principal amount. Near the end of the mortgage, the payments will be primarily principal repayments.

This is a basic example, using a traditional, plain-vanilla loan. With exotic mortgages, you can Choose Your Monthly Mortgage Payments. 

How Mortgages Amoritize

As  you can see, even though the interest portion decreases each month, the mortgage payments themselves do not decrease over time. Instead, more money is going toward the principal balance, which is fully amortized over the life of the loan. As a result, as the years go by, more of the homeowner's payment goes toward principal, accelerating the rate at which he builds equity in his home and decreases the amount he owes on it. For example, a homeowner increases his equity position by much more with each payment he makes during year 30 of a 30-year fixed mortgage than he does during years one and two.

Decreasing Payments

There are some specific situations in which mortgage payments can decrease, however. 

An adjustable-rate mortgage (ARM) is one type of mortgage that has the potential for a decreasing payment over time. This situation can happen when the loan's benchmark rate decreases over the course of the loan. However, an ARM has an equal potential to increase in payment, sometimes substantially. The loan documents stipulate how much the interest rate may increase each year, as well as the maximum it can increase over the entire term of the loan.

Another type of borrower who might see his mortgage payment decrease over time is someone who is required to pay mortgage insurance during the early years of his loan. Most mortgage companies cap loans at 80% of the purchase price or the home's value, whichever is less; the borrower is expected to come up with the other 20% on his own as a down payment. (Such loan-to-value (LTV) limits help protect the lender if the home's value drops, causing the borrower to owe more than the home is worth.) In some situations, lenders do allow homeowners to borrow more than 80% of the purchase price, but they then require mortgage insurance as part of the deal. This insurance protects the lender if it has to foreclose on a property that is worth less than the loan balance. The borrower pays the insurance premiums as part of his monthly mortgage payment.

Once the borrower's loan balance drops to a certain percentage of the home value, usually 78%, he can petition the lender to drop the mortgage insurance. Assuming he is successful, his mortgage payment decreases for the remainder of the loan, as it no longer includes a mortgage insurance premium.

To learn how to start paying down your principal more quickly, see Be Mortgage-Free Faster.