How Mortgage Loans Work

Mortgage Payments

A traditional fixed-rate mortgage payment consists of two parts: 1) the principal or unpaid balance of the loan, and 2) the interest on the loan. This does not include the property taxes and insurance which are also factored into your payments. Since the interest on the loan is based off of the unpaid principal, initial payments go more towards interest. Over time, payments cover more of the principal, therefore reducing the amount of interest.


Paying Interest

Suppose you acquired a 30-year mortgage for $100,000 at 7.5% interest. According to the amortization tables (tables used to make calculating payments easier), your monthly payment on this loan would be fixed at $699.21.

To calculate the annual interest for this loan, you would multiply the amount of the loan by the interest rate ($100,000 x .075). This amount, $7,500, is then divided by 12 (the number of months in a year), to give you a total of $625 dollars. That $625 dollars is then subtracted from the fixed monthly payment of $699.21 leaving $74.21, which is the amount that goes toward the principal for your first monthly payment.

Now that you have paid $74.21 toward the principal, your principal balance becomes $99,925.79 (this would be the difference between the original loan of $100.000 and $74.21). So, your second month’s interest goes down slightly because it is based on the new principal balance ($99,925.79 x .075). Using the same process as for the first month, but based on the new principal balance, your second months payment, allows $624.54 to go towards interest and the remaining $74.67 is applied to the principal.


Building Equity

Establishing equity helps save you money when purchasing or selling a home. What is equity? To simplify, equity is the difference between your loan amount and the balance that remains on your unpaid principal. Each payment made on your home applies a slowly increasing amount toward your principal balance. The more money applied toward the principal balance, the more equity you have. When you sell your home, even if the loan is not paid in full, you only have to pay off the remaining balance of the principal. So, you can see that building equity can benefit you greatly.


Short Term Loans

With that said, there are ways to establish equity more quickly. One way to do this is to shorten the length of your loan. In the example we gave, the loan was taken over a 30-year period of time. If you took the loan out for 15 years instead, for example, more money would be applied.