Understanding Mortgage Calculations
A mortgage is likely the largest financial commitment most people will make in their lifetime. Understanding how mortgage payments are calculated helps you make informed decisions when buying a home or refinancing.
How Mortgage Payments Work
Mortgage payments are calculated using an amortization formula that determines how much of each payment goes toward principal (the loan amount) and interest (the cost of borrowing). In the early years of a mortgage, most of your payment goes toward interest. As you pay down the principal, more of each payment goes toward reducing the loan balance.
The original amount borrowed to purchase the home. Each payment reduces the principal until it reaches zero at the end of the loan term.
The cost of borrowing money, calculated as a percentage of the remaining principal. Interest is front-loaded in mortgage payments.
The Amortization Process
Amortization is the process of spreading out loan payments over time. Here's how it works:
- The lender calculates a fixed monthly payment that will pay off the loan plus interest by the end of the term
- Early payments are mostly interest with a small principal reduction
- Over time, the interest portion decreases while the principal portion increases
- The final payments are almost entirely principal
Key Mortgage Terms to Know
- APR (Annual Percentage Rate): The true cost of borrowing, including interest and fees
- Escrow: An account for holding property tax and insurance payments
- Fixed-Rate Mortgage: Interest rate stays the same for the entire loan term
- Adjustable-Rate Mortgage (ARM): Interest rate changes periodically after an initial fixed period
- Closing Costs: Fees paid at loan signing (typically 2-5% of loan amount)
Factors That Affect Your Mortgage Payment
The more you borrow, the higher your monthly payment. Making a larger down payment reduces your loan amount.
Even a 0.5% difference in rate can significantly impact your monthly payment and total interest paid.
Shorter terms mean higher monthly payments but less total interest. Longer terms lower monthly payments but increase total interest.
These recurring costs are often included in monthly payments through an escrow account.
Mortgage Tips for Homebuyers
- Get pre-approved before house hunting to know your budget
- Compare rates from at least 3-5 lenders
- Consider both monthly payment and total loan cost
- Factor in closing costs when budgeting
- Make extra payments when possible to reduce total interest