First Home Buying

Ah, good old interest. When you’re paying interest, it isn’t very interesting at all. If you’re on the receiving end of interest payments, you’ll eventually understand where the old adage comes from that says “you’ve got to have money to make money.” Understanding how interest works in a mortgage loan is a little bit of an endeavor, but I’ll do my best to boil down the semi-complicated math so it makes (at least hopefully a little more) sense.

Interest, to put it in its simplest terms, is money that you pay to borrow money. When you put your hard-earned cash into a savings acount at the bank, the bank is borrowing your money, so they pay you interest on that money. In a mortgage loan, the opposite is true; the bank or lender lets you borrow its money and charges you a fee to pay it back over time. The amount of that fee is called the interest rate.

Compound Interest

Let’s ease into this, if we can. The vast majority of mortgages are paid off on a monthly basis. We know this and can assume that it will be true for your mortgage. The interest rate your lender has quoted you, however, is expressed as an annual figure. So if your mortgage rate is 6%, that’s the amount of interest you’re paying on the balance per year.

This means that when you first take out your loan and every time you make a payment thereafter, you pay interest based on your monthly rate, not the annual rate.

So if you had a 6% yearly interest rate on your mortgage, you’d get the monthly rate by dividing 0.06 by 12, which is 0.005, or one-half percent.

Amortization

Muerte, mort, mortis. These words mean “death” in Spanish, French, and Latin, respectively. No, that doesn’t mean that your mortgage will kill you (although some people might disagree). The word amortization is derived from a similar linguistic thread, so you can think about it as the process of “killing” your mortgage loan. You are paying off the balance over time, and the amount you owe diminishes with each payment made.

If you’ve ever looked at an amortization table, you’ll note that at the beginning of a mortgage the borrower’s monthly payment is mostly interest. Contrary to popular belief, this is not some kind of scam the lender uses to take profits early. It does work out very nicely for them though, doesn’t it?

What this phenomenon actually represents are two important facts that you need to remember when trying to understand mortgage loans:

• The monthly interest you owe on each payment is based on your loan’s remaining balance.
• Interest is always paid before principal.

Let’s use the example in the Compound Interest section above; we had a 6% yearly interest rate, which, divided by 12 months (or 12 payments per year) worked out to 0.5% monthly interest.

If we apply that to a loan for $50,000, our first interest payment would be 50,000 x 0.005 = $250.

Using the first rule above, we’ve calculated the first payment’s interest based on the loan’s remaining balance of $50,000. We also know that according to the second rule, interest is always paid first, before principal. That means that the first $250 of our payment will go toward interest, and the remaining amount in the payment is applied to the balance of $50,000.

In the following month, since the balance is less than the original $50,000, we’re only paying our monthly rate (one-half percent, in this case) on that lesser amount. The trend continues so on and so forth. Since less money is going toward interest each month as the balance decreases, more of that money goes into paying down the principal.

Payments on a fixed-rate mortgage are the same every time, and a more complex formula is used to figure out what your exact monthly payment needs to be in order for you to pay down the principal in the amount of time your loan is set for. This page is intended to show you how interest works though, not to tell you how to figure out your monthly payment. If you need to do that, check out our handy interactive mortgage calculator.

Annual Percentage Rate

One last note about interest. You’ve probably heard the term APR before, and a lot of people are confused about what that really means. Well, to put it bluntly, the basic interest rate you get on your loan is fine and dandy, but the actual percentage you’re paying to borrow the money increases when you include any fees, insurance, or points you have to pay on the loan. The APR is not necessarily representative of the real cost of borrowing, but it does provide a decent standard that can be used to compare various lenders and loans. Any fees that would otherwise be “hidden” in the advertised rate must be included in this figure.