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Mortgage Loans - How They Work

Are you wondering what goes into a mortgage payment? Essentially, when speaking of a traditional fixed rate mortgage payment, it is comprised of two main components - the principal (the remaining, unpaid balance of the loan), and the interest (the interest on the loan).

When looking at the life of the loan, the begining of the loan period looks significantly different than the latter period. Why? Simply, the first part of your mortgage payments are paying mostly interest, and the latter payments are mostly toward the principal of the loan. To further explore how dramatically a mortgage payment will change over the years, let's look at an example. 

Example of a Traditional Mortgage Payment

Note: this mortgage payment example does not include property taxes or insurance. 

Amortization Table is the key word when laying out the life of a loan. lenders use amortization tables as an easy way to determine and show how much of each payment is going toward interest, and how much of the payment is going toward the principal.

As mentioned previously, how much of the mortgage payment is going to interest decreases as the number of years of the loan grows. In our example, we will use a 30-year loan for $150,000 at a fixed rate of 6.5%. The images below show the first year of payments and the last year of payments. If you look at the principal and interest columns, you will see a dramatic difference in the two. 

First Year Mortgage Payments

Pmt. # Date Loan Balance Interest Principal Total Interest
1 February 1, 2015 149,864.40 812.50 135.60 812.50
2 March 1, 2015 149,728.06 811.77 136.34 1,624.27
3 April 1, 2015 149,590.99 811.03 137.08 2,435.29
4 May 1, 2015 149,453.17 810.28 137.82 3,245.58
5 June 1, 2015 149,314.60 809.54 138.56 4,055.11
6 July 1, 2015 149,175.29 808.79 139.31 4,863.90
7 August 1, 2015 149,035.22 808.03 140.07 5,671.94
8 September 1, 2015 148,894.39 807.27 140.83 6,479.21
9 October 1, 2015 148,752.80 806.51 141.59 7,285.72
10 November 1, 2015 148,610.44 805.74 142.36 8,091.46
11 December 1, 2015 148,467.32 804.97 143.13 8,896.44

 

 

 

 

 

 

 

 

 

 

Last Year of Mortgage Payments

Pmt # Date Loan Balance Interest Principal Total Interest
348 January 1, 2044 10,986.57 64.30 883.80 190,926.08
349 February 1, 2044 10,097.98 59.51 888.59 190,985.59
350 March 1, 2044 9,204.58 54.70 893.40 191,040.29
351 April 1, 2044 8,306.33 49.86 898.24 191,090.15
352 May 1, 2044 7,403.23 44.99 903.11 191,135.14
353 June 1, 2044 6,495.22 40.10 908.00 191,175.24
354 July 1, 2044 5,582.30 35.18 912.92 191,210.42
355 August 1, 2044 4,664.44 30.24 917.86 191,240.66
356 September 1, 2044 3,741.60 25.27 922.84 191,265.93
357 October 1, 2044 2,813.77 20.27 927.84 191,286.19
358 November 1, 2044 1,880.91 15.24 932.86 191,301.43
359 December 1, 2044 942.99 10.19 937.91 191,311.62
Pmt # Date Loan Balance Interest Principal Total Interest
360 January 1, 2045 0.00 5.11 942.99 191,316.73

So how do they come up with these numbers?

The monthly mortgage payment on this loan is $948.10 (the combined principal and interest). This is a fixed amount because the interest on the loan is fixed.

To figure out the first payment, you will need to first calculate the annual interest, and then divide that number by 12 (12 months in a year).

          Annual interest: $150,000 x .065 (6.5%) = $9,750

          then, $9,750 / 12 = $812.50

If you compare this amount to the amount in the amortization table in the "interest" column, you will see it matches. 

Next, you will subtract the first interest payment from the total fixed monthly payment:

          $948.10 - $812.50 = $135.60

If you compare this amount to the amount in the amortization table in the "principal" column, you will see it matches. 

To come up with the new loan balance (the unpaid balance), you will need to subtract $135.60 (the principal paid) from the original loan amount of $150,000.

          $150,000 - $135.60 = $149,864.40

From there, payment two and beyond, you would just repeat the same steps - just with the new loan balance each time:

          $149,864.40 x .065 (6.5%) = $9,741.186

          $9,741.186 / 12 = $811.7655 (this would round to $811.77 on the table) - total interest paid for payment two.

          $948.10 - $811.7655 = $136.3341666667 (this would round to $136.34 on the table) - total principal paid for payment two.

          $149,864.40 - 136.34 = $149,728.06 (the new loan balance)

Note: It is important to note that residents In Canada will calculate their payments differently. They are compounded semi-annually instead of monthly (the example shown above).

Taking time to look at an amortization schedule allows the borrower to see how a loan is structured, and how building equity in a home works. As you pay down the loan, you are building equity in a home. The equity in a home is not only the principal that you pay down through an initial down payment and monthly principal payments. Market Value also plays a role in a home's equity. For example, when someone sells a home, they sell the home at market value. If a home was purchased for $100,000, with principal payments of $25,000, they would owe the remaining balance ($75,000) on the home loan. This is true whether the home sells at $150,000, $200,00, or any other amount. Therefore, as a homeowners pays down their interest, and the Market Value of their home increases, the more equity they are building. Similarly, if a home decreases in Market Value, then the homeowners are losing equity in their home with regards to the market side. They would still gain equity, however, as their debt is lowered monthly (pending the home does not have a market value lower than the loan amount). As a whole, the overall equity of the home is variable. 

Saving on the Interest

A way to save on interest is to take a shorter loan. For example, instead of taking a 30 year loan, you can take a 15 year loan. Using the example above, a $150,000 at 6.5% fixed interest rate will end up costing $191,316.73 in interest alone. If you took the same loan over 15 years instead, the total interest would be $85,198.99. That is a difference of $106,117.74! The monthly payment on the 30 year loan (without taxes and insurance) would be $948.10. The monthly payment on the 15 year loan (without taxes and insurance) would be $1306.66,

It is always important to consider each individuals situaition independantly. A shorter loan might not be the best solution for everyone's needs. If you need assistance in purchasing your next home, be sure to contact us and we will walk you through the process step by step and answers any questions and address concerns you might have.