If you own a home, you probably know that a portion of what you pay the lender each month goes toward the original loan amount while some gets applied to the interest. But figuring out how banks actually divvy those up can seem confusing.
You may also wonder why your payment stays remarkably consistent, even though your outstanding balance keeps going down. If you understand the basic concept of how lenders calculate your payment, however, the process is simpler than you might think.
- Mortgage payments are made up of two components. The principal is the amount of the loan itself and the interest is the monthly amount that the lender charges you on top of the principal.
- With fixed-rate mortgages, your monthly payment is consistent because of a process called amortization.
- In addition to the principal and interest that you pay the lender, your monthly payment may also include other expenses such as mortgage insurance premiums and taxes held in escrow.
Principal and Interest
Each mortgage payment that you make is made up of two main components: principal and interest.
Principal is the original loan amount. Suppose you purchase a $350,000 home and put down $50,000 in cash. That means you’re borrowing $300,000 of principal from the lender, which, of course, wants you to pay that money back.
But the bank is also charging a fee for lending you those funds, which is represented by the interest portion of your payment. Let’s say you’re paying a 30-year mortgage with a 4% annual interest rate.
Because you’re making monthly, rather than annual, payments throughout the year, that interest rate gets divided by 12 and multiplied by the outstanding principal on your loan.
In this example, your first monthly payment would include $1,000 of interest ($300,000 x 0.04 annual interest rate ÷ 12 months).
How Amortization Works
You may be wondering, then, why your mortgage payment—if you have a fixed-rate loan—stays the same from one month to the next. In theory, that interest rate is being multiplied by a shrinking principal balance. So shouldn’t your monthly bill get smaller over time?
The reason that’s not the case is because lenders use amortization when calculating your payment, which is a way of keeping your monthly bill consistent. The mortgage servicer makes up for the fact that you’re paying a higher interest charge in your first few years by allowing you to make a smaller payment against the principal.
If you plug your purchase price, your down payment, the length of your loan, and your APR (see more on this below under "Interest Rate vs. APR") into the Investopedia Mortgage Calculator, you will see that your monthly payments to the lender would equal $1,432.25. (You may also pay for things like mortgage insurance and property taxes held in escrow, although those don’t go to the actual lender.) As we noted earlier, $1,000 of your first payment strictly covers the cost of interest. That means the remaining $432.25 is paying down your outstanding loan balance or principal.
Assuming you don’t refinance, your loan payment will be the same 15 years later. But by now you’ve chipped away at your principal balance. Now you owe roughly $193,000 of the principal on your loan. When you multiple that balance by your interest rate (0.04 ÷ 12 months), you’ll find that the interest portion of your payment is now only $643.43. But you’re paying off a bigger portion of your principal: $786.82.
During the last few years of your mortgage, you’re paying off an even larger principal amount each month as your interest charge decreases. By leveling out your payments like this, lenders are actually making your payments more manageable. If you paid the same amount in principal over the course of the loan, you’d have to make much higher monthly payments right after taking out the loan, and then see those amounts plummet at the tail end of the repayment.
If you’re wondering how much you’ll pay toward principal versus interest over time, the Investopedia Mortgage Calculator also shows the breakdown of your payments over the length of your loan.
If you take out a fixed-rate mortgage and only pay the amount due, your total monthly payment will stay the same over the course of your loan. The portion of your payment attributed to interest will gradually go down, as more of your payment gets allocated to the principal. But the total amount you owe won’t change.
However, it doesn’t work that way for borrowers who take out an adjustable-rate mortgage, or ARM. They pay a given interest rate during the initial period of the loan. But after a certain length of time—say, one year or five years, depending on the loan—the mortgage “resets” to a new interest rate. Often, the initial rate is set below the market rate at the time you borrow, and then increases following the reset.
Suddenly, you’ll notice that your monthly payment has changed. That’s because your outstanding principal is being multiplied by a different (usually higher) interest rate.
Interest Rate vs. APR
When receiving a loan offer, you may come across a term called the annual percentage rate, or APR. The APR and the actual interest rate that the lender is charging you are two separate things, so it’s important to understand the distinction.
Unlike the interest rate, the APR factors in the total annual cost of taking out the loan, including fees such as mortgage insurance, discount points, loan origination fees and some closing costs. It averages the total cost of borrowing over the duration of the loan.
It’s important to realize that your monthly payment is based on your interest rate, not the annual percentage rate. However, lenders are required by law to disclose the APR on the loan estimate they provide after you submit an application, so that you can have a more accurate picture of how much you’re actually paying to borrow that money.
Some lenders may charge you a lower interest rate but charge higher upfront fees, so including the APR helps provide a more holistic comparison of different loan offers. Because the APR includes associated fees, it’s higher than the actual interest rate.
How Is My Interest Payment Calculated?
Lenders multiply your outstanding balance by your annual interest rate, but divide by 12 because you’re making monthly payments. So if you owe $300,000 on your mortgage and your rate is 4%, you’ll initially owe $1,000 in interest per month ($300,000 x 0.04 ÷ 12). The rest of your mortgage payment is applied to your principal.
What Is Amortization?
Amortizing a mortgage allows borrowers to make fixed payments on their loan, even though their outstanding balance keeps getting lower. Early on, most of your monthly payment goes toward interest, with only a small percentage reducing your principal. At the tail end of repayment, that switches—more of your payment reduces your outstanding balance and only a small percentage of it covers interest.
What’s the Difference Between Interest Rate and APR?
The interest rate is the amount that the lender actually charges you as a percent of your loan amount. By contrast, the annual percentage rate, or APR, is a way of expressing the total cost of borrowing. Therefore, APR incorporates expenses such as loan origination fees and mortgage insurance. Some loans offer a relatively low interest rate, but have a higher APR because of other fees.
The Bottom Line
You likely know how much you're paying to the mortgage servicer each month. But figuring out how that money is divided between principal and interest can seem mysterious. In fact, figuring out how much you're paying in interest is as simple as multiplying your interest rate by your outstanding balance and dividing by 12. It's only because lenders adjust the amount credited to your original loan balance that your payments stay remarkably consistent over the years.