Principal And Interest: Defined And Explained

When you take out a mortgage, you’ve made an agreement to make monthly payments to your lender for a predetermined amount of time – most often 15 or 30 years – until the loan is paid off. However, especially if you’re a first-time home buyer, you may not fully understand how your mortgage payments are determined. Simply put, it all comes down to principal and interest.

Up next, we’ll take a closer look at the concept of mortgage interest and principal, and how they help dictate how much you’ll owe each month.  

Mortgage Principal Definition

Your mortgage principal is the original loan amount that you borrow from your lender when you get a mortgage. To determine your mortgage principal, just take the sales price of your home and subtract the amount of your down payment. For example, let’s say you bought a home for $375,000 and put 20% down. Here, your principal balance would be $300,000.

Each month, part of your mortgage payment will go toward lowering your principal balance. It’s important to be aware that the principal starts accumulating interest as soon as you close on your loan.  

Mortgage Interest Definition

When you take out a mortgage, your lender will charge you a fee for the loan. This fee is more commonly known as interest. In addition to paying down your principal balance each month, you’ll pay interest to your lender.

The amount of interest you pay over the life of your loan will depend on your interest rate. When you apply for a mortgage, your lender will evaluate your eligibility and offer you an interest rate based on factors that include your: 

• Credit score
• Income
• Down payment
• Debt-to-income ratio
• Housing market

How Is Mortgage Interest Calculated?

To calculate your interest payment, your lender will divide your annual interest rate by 12 because you make monthly payments on your mortgage. That number is then multiplied by your principal balance to determine how much you’ll pay in interest. For example, let’s say you have a loan balance of $300,000 and an interest rate of 5%. After doing the math (.05 ÷ 12 x $300,000), you’ll initially pay $1,250 in interest per month, with the rest of your mortgage payment being applied to your principal.

Interest With A Fixed-Rate Mortgage

Mortgages can be broken down into several categories, one of which is fixed-rate vs. adjustable-rate. With a fixed-rate mortgage, you’re locked into the same interest rate throughout the duration of the loan. If you have a fixed-rate mortgage and make your regularly scheduled payments, you can expect your monthly payments to remain the same over the life of the loan.

Interest With An Adjustable-Rate Mortgage

If you have an adjustable-rate mortgage, your interest rate changes after a predetermined amount of time. Often, homeowners with an adjustable-rate mortgage find that their monthly payment goes up after the introductory period of the loan because their interest rate increases.

Interest Rate Vs. APR

Another term that’s important to know when discussing mortgage interest rates is annual percentage rate (APR). APR measures the total cost of borrowing over the life of the loan, taking into account factors like mortgage insurance, origination fees, closing costs and discount points. Lenders are required to disclose APR to give borrowers a more accurate picture of what it costs to take out a loan. When shopping around for the most favorable loan terms, comparing the APR offered by different lenders can help you ensure you’re choosing the best loan for your needs.

How To Calculate Principal And Interest

A mortgage calculator will allow you to see the amount of principal and interest you’ll pay over the life of your loan, assuming you make only your required payment each month – nothing more and nothing less. Mortgage calculators can be a valuable tool for seeing how your money will be used. Additionally, a mortgage amortization calculator can help you understand how much of each monthly payment goes to your principal and how much goes to interest.

Understanding Mortgage Amortization

Mortgage amortization is the schedule by which you will pay off a loan with regular monthly installments. In the early years of a loan, most of your monthly payment will go toward interest, with only a small amount aimed at reducing the principal balance. This switches toward the end of the loan term, with the majority of your mortgage payment going to the principal balance.

Because you pay interest on your principal balance, making extra payments toward your principal can save you thousands of dollars over the life of the loan. Crunching some numbers with a mortgage amortization calculator can give you a better idea of the impact that additional payments toward your principal can have on the total cost of your home loan.  

Other Components Of Your Monthly Mortgage Payment

While your principal and interest make up most of your monthly mortgage payment, you may also pay money into an escrow account as part of your mortgage payment each month. Your lender will then take the money in your escrow account to pay important mortgage-related expenses on your behalf. These expenses most often are: 

• Property taxes: All homeowners must pay a property tax, which goes to their local government to fund public services like education, transportation, recreation and public safety. The amount you’ll owe in property taxes each year depends largely on your property value and property tax rates in your area.
• Homeowners insurance: Most mortgage lenders require you to have homeowners insurance as a form of financial protection. In the event that your home is damaged by certain kinds of accidents or circumstances like fire or vandalism, homeowners insurance will likely help cover the cost of repairs. The amount you’ll owe in homeowners insurance depends on factors such as the value and location of your home, as well as any additional risk factors your home may have.

If the amount you owe in homeowners insurance, property taxes or both changes over the life of your loan, your lender will reassess the amount you pay into escrow each month and raise or lower your monthly payment accordingly to ensure these costs remain covered.

The Bottom Line On Mortgage Principal And Interest

Your mortgage principal is the amount you borrow from your lender, while interest is a percentage of your principal that you pay as a fee for borrowing the money. The combination of these two elements primarily makes up your monthly mortgage payment, though you’ll likely pay additional money into an escrow account for homeowners insurance and property taxes.

If you’re beginning the home-buying process, the first step is securing your initial mortgage approval, and the Home Loan Experts at Rocket Mortgage^® are ready to help. Start your application online today.