How a mortgage payment is calculated
A mortgage payment looks like a single number, but it is assembled from several parts that behave differently over time. Understanding the assembly makes it much easier to see why two loans with the same headline rate can cost very different amounts, and why the balance falls so slowly at first.
The four components
Most monthly payments contain principal, interest, and — where the lender collects them — property taxes and insurance held in an escrow or impound account.
Principal reduces what you owe. Interest is the cost of borrowing. Taxes and insurance are not loan costs at all; they are your bills, collected monthly and paid on your behalf so a large annual charge does not arrive all at once.
How the principal and interest figure is set
A repayment mortgage uses an amortisation calculation. It finds the single fixed payment that will clear the balance exactly over the term at the given rate. Three inputs decide it: the amount borrowed, the interest rate, and the number of months in the term.
Each month, interest is charged on the balance that remains. That interest is taken out of your payment first, and whatever is left reduces the balance. Because the balance is largest at the start, the interest slice is largest at the start.
Why the balance barely moves in the early years
On a long-term loan at a typical rate, the first payments can be overwhelmingly interest. The split shifts gradually: as the balance falls, the interest charged falls with it, so more of the same fixed payment goes to principal. Late in the term, almost all of it does.
This is also why overpayments made early are worth so much more than the same overpayment made later. Money put against the balance in year two avoids interest on that amount for the rest of the term.
What changes the payment
Lengthening the term lowers the monthly payment and raises the total interest paid, sometimes dramatically. Shortening it does the reverse. A lower rate lowers both. A larger deposit lowers the amount borrowed, which lowers both, and may unlock a better rate band as well.
Taxes and insurance change independently of the loan. This is why a payment can rise even on a fixed-rate mortgage — the loan part has not moved, but the escrow part has.
Reading a loan estimate properly
When comparing offers, look past the monthly figure. Check the rate, the term, whether the rate is fixed and for how long, the fees rolled into the deal, and whether the quoted payment includes taxes and insurance. Two quotes that differ by a few units per month can differ by a great deal over the full term.
- Amount borrowed and deposit
- Interest rate, and how long it is fixed for
- Term in years, and the total interest across it
- Fees, and whether they are paid upfront or added to the balance
- Whether the payment shown includes taxes and insurance
Go750 publishes educational information about money and housing. This article is not financial advice and Go750 does not offer or arrange financing.
