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Principal and mortgage interest are the two key components of your monthly mortgage payment when you borrow money to buy a home. Your principal payment is what allows you to get out of debt. Your interest payment is what allows you to borrow money. Here’s a detailed breakdown of how mortgage interest and principal works and how it’s calculated.
What is mortgage capital?
Mortgage principal is the amount you borrow from a lender to buy a home. A portion of each monthly payment you send will go toward reducing your mortgage principal.
You may already be familiar with the concept of capital from another type of loan you have taken out. If you borrowed money to pay for your education, that amount was the principal of your student loan. If you took out a loan to buy your car, the price of the car minus your down payment is your car loan principal.
What is mortgage interest?
Mortgage interest is the price you pay a lender to borrow the capital to buy your home. Each month, a portion of your payment will be used to pay interest. Look at your mortgage statements to see how much of your most recent payment was for interest and how much for principal.
Most people claim the standard deduction on their tax return. However, a small percentage of homeowners save more money by itemizing their deductions and claiming the mortgage interest deduction.
Mortgage interest on mortgage debt of up to $ 750,000 is an expense that you can itemize as long as you have incurred the debt to build, buy, or significantly improve the home. Combining this expense with charitable donations and property taxes can cause you to exceed the standard deduction threshold, which is $ 12,200 for single tax filers and $ 24,400 for married tax filers in 2020.
Example of principal and interest
Suppose you buy a house that costs $ 250,000. You put in 20%, or $ 50,000. The principal amount of your mortgage is the price of the house less the down payment, or $ 200,000.
Say you want to pay off the $ 200,000 in principal over 30 years. To lend you this money, the lender needs an incentive: the ability to earn interest at a fixed rate of 3% per annum for 30 years.
Using an online mortgage principal and interest calculator (also known as just a mortgage calculator), you can see how much 3% interest on your loan balance over 30 years will cost: $ 843 per month in principal and interest. Check the calculator’s amortization schedule and scroll to the repayment date. It will show that you will pay $ 103,601.28 in interest over 30 years to borrow $ 200,000 in principal.
Understanding mortgage amortization
Amortization of the loan is the split of the principal and interest that you owe over a predetermined period. In the case of a 30-year mortgage, this period is 360 months. If you get a 15-year mortgage, that period is 180 months.
Auto loans and student loans are also amortized. Before taking out an amortized loan, you can use a calculator to find out its amortization schedule. This calendar shows you exactly how much of your fixed monthly payment will go to principal and interest each month.
How do you calculate the principal and the interest?
You can use a mortgage calculator to show you how much principal and interest you’ll pay over the life of your mortgage, and you can use an amortization calculator to see how much principal and interest you’ll pay each month. It can be helpful to know the math behind the calculator to understand where your money is going.
Your first mortgage payment
In the first month, you owe your lender $ 200,000, the total amount you borrowed. Your interest rate is 3% per annum, which means it’s 0.0025% per month (3% divided by 12). In one month, you accumulate $ 500 in interest.
Interest accrues during the month. So by the time you make your first mortgage payment, you will have been on your loan for at least a month. If you’ve had it longer, say you closed your loan on the 15th, you’ll have prepaid a few weeks of interest as part of your mortgage closing costs.
So you pay $ 500 interest in the first month. We determined earlier that your monthly payment will be $ 843. Why this amount? This is the amount that amortization calculations show you have to pay each month to pay off your loan after making 360 payments. This means that the remaining $ 343 of your first monthly payment will go towards paying off your mortgage principal.
Pay more principal, less interest over time
In the second month, you owe your lender $ 199,657 (that’s $ 200,000 minus $ 343). At 0.0025% monthly interest, $ 499.14 of your next mortgage payment will be interest and $ 343.86 will be principal.
And for each month to come until you pay off your loan, two things will happen:
- The amount of your payment that goes towards the principal will increase slightly.
- The amount of your payment that goes towards interest will decrease slightly.
As you pay off your mortgage principal, you have a smaller balance to earn interest on. Since your monthly payment stays the same every month, the lender allocates more of your principal payment because you don’t owe so much interest.
This way, you will be able to pay off your mortgage on a regular basis over 30 years. Your 359th payment will be split at $ 838.50 in principal and $ 4.50 in interest. Your 360th payment will be a little larger, at $ 964.28, to eliminate the remaining balance; $ 961.88 will go to principal and $ 2.40 to interest.
How Taxes and Insurance Factor in Your Mortgage Payment
Property taxes and home insurance may be included in your mortgage payment if your lender requires you to escrow these payments. Your lender may require a mortgage escrow account if you deposit less than 20%, and it is required if you get an FHA or USDA loan.
Let’s say your property taxes are $ 2,500 per year and your home insurance is $ 1,000 per year. Your lender will divide each amount by 12 so that you pay your taxes and insurance gradually over the year.
The lender holds this money in your escrow account and then sends the money to your local collector and insurer when payments are due. Your monthly mortgage payment would be $ 1,134.67 after adding the $ 291.67 per month for taxes and insurance to your principal and interest payment of $ 843.
If you have to pay for private mortgage insurance or flood insurance, your lender will also block these amounts.
How to pay off your mortgage faster
You can pay off your mortgage faster by making additional principal payments. The key for this strategy to work is that you must specify that the extra money you are sending is an additional principal payment. If you don’t, your mortgage agent might apply it to your next monthly payment, which won’t give you the result you’re looking for.
Do you receive an annual bonus, do you have irregular income or do you benefit from a large tax refund? One way to pay off your mortgage faster is to make an extra payment per year when that extra income arrives. On a 30-year mortgage where you make an additional principal payment per year, you will pay off your mortgage approximately 3.5 years sooner. In our example of a $ 200,000 mortgage at 3% interest, you would save just over $ 14,000 in interest by using this strategy to pay off your mortgage sooner.
Are your income stable throughout the year? In this case, you may want to pay additional principal with each monthly payment. You may be able to set up this arrangement through your provider’s website so that it happens automatically every month.