Often times people are surprised to learn that the amount you pay towards interest and principal varies dramatically over time. This is because mortgage loans work in such a way that the early payments (during the early years of the loan) are applied primarily towards interest, while the later payments (during the later years of the loan) are applied primarily towards the principal.

In The Beginning You Pay Mostly Interest

To calculate monthly mortgage payments, lenders use what are known as “amortization tables”. These tables make it fairly easy to calculate how much of each payment is applied towards interest and how much towards the principal balance.

For example, let’s calculate the principal and interest for the first monthly payment of a 30-year, $100,000 mortgage carrying a fixed interest rate of 7%. Utilizing the amortization tables, the monthly payment for this loan is fixed at $665.30.

To determine the interest and principal portions of this payment, we calculate the annual interest by multiplying $100,000 x .07 (7%). This equals $7,000, which we divide by 12 (the number of months in a year) to arrive at the interest portion for the first monthly payment - $583.33. You then subtract $583.33 from the monthly payment of $665.30 to arrive at the amount of the payment applied towards the principal balance (reduces the principal balance) - $81.97.

To determine the interest and principal portions of the second payment, we deduct $81.97 from the previous month’s loan balance ($100,000), to arrive at the unpaid principal balance of $99,918.03. To compute the amounts applied towards interest and principal for the second month’s payment, we just repeat the steps described in the previous paragraph. Thus, we calculate the annual interest by multiplying $99,918.03 x .07 to arrive at $6,994.26. We then divide this amount by 12 to arrive at the interest portion for the second monthly payment - $582.86. You then subtract $582.86 from the monthly payment of $665.30 to arrive at the amount of payment applied towards the principal balance - $82.45.

Note: These computations apply to typical mortgages in the U.S., and may not be accurate for other countries, because of possible differing compounding methods. We suggest you check with your lender.

Equity

As you’ll notice in the above example, even though you pay a lot of interest in the early years of the loan, you are also slowly paying down your overall debt. Therefore, even if you sell your home before the loan is paid in full, your remaining obligation to the lender is only the unpaid principal balance of your loan (plus interest to the payoff date and any pre-payment penalties, if applicable).

The difference between what your home is worth (the value, or sales price if selling your home) and the remaining principal balance is known as “equity”. There are two ways that you increase the equity in your home:

· Making Payments on Your Mortgage As you can see from the above examples, by making your minimum monthly mortgage payments (presuming no negative amortization), you will reduce the unpaid principal balance of your loan, thereby increasing your equity each month (Equity = home value – mortgage balance). You can increase the amount of equity you build in your home by making additional principal payments on your loan or by choosing a shorter loan term when you first secure your mortgage (for example, a 15 year loan vs. a 30 year loan).

· Increasing Property Values As home values increase in your neighborhood, your equity in your home also increases (presuming you are not increasing your principal mortgage balance or securing additional debt against your home). We refer to the increase in home values over time as “appreciation”. The greater the housing market increases in your area, the faster you build equity in your home. The increasing equity is like a built-in savings account for you. Most likely at some point in the future you will sell your home and reap the benefits of this built-in savings account (presuming values do not decline in your area).

Equity is just one of the benefits of home ownership. I would be happy to discuss other benefits with you. Simply give ME a call and I’ll glady assist you.