Mortgage Principal & Interest: Do You Know How They Work? We're Here to Help You

By Chika

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Last Updated: November 3, 2022

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There are two basic components that make up every mortgage payment - principal and interest. However, many homebuyers are unaware of the differences in both terms, and sometimes use them interchangeably. 

Understanding both principal and interest can help you choose the best mortgage option for you.

In this article, we’ll share everything you need to know about principal and interest. We’ll cover the differences between the two and help you determine what you owe, or will pay, on your mortgage.

 

 

What is Mortgage Principal?

The initial loan amount you took out to purchase your house is known as the mortgage principal.

It isn't the price you bought for your house or the sum of your regular mortgage payment.

For example, you purchase a home for $450,000 with a 20% down payment. This suggests a $90,000 down payment on your loan. Your mortgage lender would then cover the cost of the remaining amount on the loan, which is $360,000. In this case, your principal balance is $360,000.

When you make a payment each month, a portion goes toward the principal balance of the loan, a portion goes toward the interest payment.

The main balance of your mortgage will fluctuate over the course of your loan as you pay it off with your regular monthly payment and any additional payments. While you reduce your mortgage's principal, your equity will rise.

 

 

What is Mortgage Interest?

The fee for borrowing the principal amount of a mortgage is known as mortgage interest.

Both are covered by your monthly mortgage payment, though you probably won't get a breakdown of how much of it is made up of principal and how much is interest.

Most lenders calculate and determine your mortgage rate in terms of an annual percentage rate (APR).

This is the actual amount of interest that you pay on your loan per year (APR includes your mortgage rate and fees/costs). Using our example, if you borrow $360,000 at an APR of 5%, you’d pay a total of $23,190.72 annually in interest. 

Bear in mind that just a few percentage points of interest can make a huge difference in how much you eventually end up paying for your loan.

Using our example, let’s say you borrow $360,000 at a 4% interest on a 30-year loan. With this loan, your annual payment would come to $20,624.

The interest rate on your loan depends upon a number of  factors.

These can all influence how much you pay in interest:

  • credit score
  • income
  • down payment
  • the location of your home

So having knowledge of how these factors affect your interest rate can help you negotiate for lower rates when applying for mortgage. 

 

Total Monthly Payment

Your monthly payment isn’t just made up of principal and interest. lenders typically include principal, interest, taxes and insurance (PITI) when determining how much house they will approve you for.

 

Taxes

Taxes are among the most expensive and sometimes disregarded expenses of house ownership.

Your local government receives funding from property taxes for services like public schools, roads, fire departments, and libraries.

The value of your house and the local amenities that your neighborhood provides determine how much you pay in taxes.

Getting an appraisal when you purchase a house is necessary in part so that your local government can accurately determine your taxes. Taxes might change year to year, and depending on your county, you might need to acquire an updated appraisal every few years.

Property will be valued by tax assessors, who will then impose the appropriate rate on homeowners in accordance with tax authority guidelines. They determine that value by either utilizing the mill levy or the assessed value of the property (which is based on local real estate market conditions).

 

Insurance

Though you are not required to have homeowners insurance to own a home, most lenders refuse to give loans without insurance.

With homeowner's insurance, you're protected against damage from things like lightning, fires, and break-ins, to mention a few. You may need an additional policy to protect yourself from damage caused by flooding and earthquakes.

Your homeowners insurance depends on a number of factors such as location, value, proximity to fire station or police station. Additional risk factors such as age of home or owning a swimming pool can also impact insurance costs. 

 

Escrow

Your monthly mortgage payment may be deducted by your mortgage lender as part of an escrow account.

What you owe in real estate taxes and insurance premiums is kept in an escrow account. To make sure you pay your insurance and tax obligations on time, lenders gather this money and make the payments on your behalf.

Your property tax and insurance rates will determine the exact amount you pay in escrow. When your taxes or insurance changes, your lender may reassess your escrow payments.

 

 

Can the Monthly Principal Change?

In most mortgage contracts, your monthly mortgage payment will remain constant until the debt is repaid.

However, if you pick an adjustable-rate mortgage (ARM) or make extra loan payments, there are two situations where your monthly payment (or the number of years you have to pay your mortgage) could change.

 

Adjustable-Rate Mortgage (ARM)

With an ARM, your interest rate will fluctuate in line with market rates.

With an ARM, you typically get a few years of cheap fixed interest rates. When that promotional period expires, your prices will vary in accordance with the market. Your rate increases if market rates do and vice versa.

Due to the fact that your interest rate can change, this could alter your monthly mortgage payment. The introductory rate is lower than the normal fixed-rate mortgage, which has an interest rate that stays the same for the duration of the loan.

 

Make Extra Payments

If you pay off more of your loan than you originally planned to, your mortgage payment may alter.

This is so that interest is only charged on the amount you actually owe. At the start of your loan, interest makes up the majority of your monthly payment.

Your main balance and the amount of interest you owe will gradually decrease as a result of the monthly payment you make.

This procedure, known as "mortgage amortization," gradually lowers your principal balance and the amount of interest you owe.

Paying just a little bit more each month toward your principal can help you save a significant amount of money. Say, for illustration, that you have a $360,000 loan with a 30-year term and a 4% interest rate. Your mortgage payment each month would be $1,719. 

You could save $30,171 in interest over the course of your loan if you paid an extra $100 a month. Additionally, by making the extra payments, you would pay off your loan 2 years sooner than you otherwise would.

You can think about budgeting some extra cash each month to reduce your principal balance with an additional principal payment. Make sure to inform your lender that the additional payment should only be applied to the principal.

 

 

How to Stay on Top of Your Mortgage Principal and Interest

Examining your monthly mortgage statements is the simplest way to stay on top of your mortgage's principal and interest.

You'll receive a statement from the mortgage servicer that details how much you paid each month toward the principal as well as how much was deducted from it. The numbers are available in your online account, if you have one.

 

 

The Takeaway

Understanding the ins and outs of principal, interest, and amortization schedules for a mortgage can be a very useful tool for speeding up principal repayment and reducing interest costs.

Photo by David Gonzales

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