Principal payments and interest explained
Mortgages can seem like a foreign concept to first-time homebuyers. Unlike rent, which is pretty straightforward, mortgage payments include a variety of built-in costs. The two biggest expenses: the loan principal and interest.
Understanding principal payments and mortgage interest is key to accurately calculating your mortgage payments. And that, in turn, will help you budget for your monthly housing costs. Let’s pull back the curtain on principal and interest so you can see where your money is going when you pay your mortgage.
What is the principal balance on a loan?
The principal balance on your mortgage is simply the total amount you owe on your home loan. In other words, it’s the money your mortgage lender loans to you when you buy a house. The principal doesn’t account for interest or other costs that go into your monthly payment, like property taxes and homeowners insurance.
Principal vs. interest: What you need to know
Because the principal is the amount of your loan, and nothing more, it only represents a portion of your mortgage payment — albeit a pretty large one. Interest is the other major cost you need to consider when projecting your future housing costs. Take a look at any reliable mortgage calculator, and you’ll see that paired together, principal and interest account for a huge portion of your monthly mortgage payment — sometimes as much as three-quarters of the total amount.
Interest is the charge mortgage lenders tack on as compensation for their financing services. They’re not handing out home loans for free, after all. Mortgage interest is calculated as a percentage of the loan amount, which is then added to the principal, property taxes, insurance premiums and other housing costs.
In short, principal is the loan itself while interest is the lender’s charge for extending the mortgage in the first place. Acquiring a loan is a privilege extended to certain qualified homebuyers, after all. And lenders rightly should and need to be compensated for offering this privilege.
Every principal payment builds equity in your home, which you could then use to take out a home equity loan or a home equity line of credit (HELOC). Many homeowners do so to cover the cost of big-ticket items like home renovations, college tuition and unforeseen emergencies.
Paying interest alone doesn’t build equity since that money goes directly to the lender to cover servicing costs — as well as set aside a small percentage as profit. Amortization schedules are usually structured in such a way that borrowers pay more interest at the outset of the loan. During the life of the loan, mortgage payments will gradually cover more of the principal with each passing year.
Keep in mind that interest is paid in arrears. For instance, your September payment will cover the principal plus interest on the outstanding principal balance in August. Although your payment never changes, the split constantly fluctuates — even if you add just a few extra dollars each month in principal.
Mortgage lenders weigh a lot of factors when setting an interest rate: your credit score, existing debt and liquid assets, to name just a few. They also look at macro factors completely out of your control like the state of the global economy, bond market performance, recent housing trends and cost of funds.
Every lender will have their own algorithm or formula for weighing this criteria, so you can expect interest rates to fluctuate from lender to lender. Point being: You should shop around and find a trusted lender if you want to get the best rate for your financial situation.
How to calculate principal and interest
You don’t need a fancy mortgage principal calculator to figure out roughly how much principal you owe. Some quick math will give you an approximate answer. Simply take your total loan amount, divide it by the loan term and then divide that number by 12. Voila, there’s your monthly principal!
Now, if you’ll recall, interest payments are based on the previous month’s principal. At the same time, your total monthly payment never changes, but the split between principal and interest does. So, you won’t put exactly the same amount toward your principal every month since that breakdown changes during the life of your loan.
Of course, that’s assuming you have a fixed-rate mortgage and not an adjustable rate mortgage, which would then recalculate your interest rate at a set interval after an initial term has passed. For example, a 5/6 loan would change every six months after the initial five years of a fixed rate. A 10/6 loan would reset every six months after an initial 10-year period of fixed rate payments, and so on.
Compared to the relative simplicity of principal payments, figuring out how much you’ll pay in interest is much more complicated. If you want a very rough estimate of your monthly interest payment, you could simply multiply your monthly principal by your mortgage rate.
However, keep in mind that your interest rate doesn’t necessarily account for additional loan fees that you pay out of pocket like origination charges and closing costs. Instead, it’s more accurate to use your annual percentage rate (APR), which bundles together everything you owe your lender.
Even then, you might not get a 100% accurate result because, again, your amortization schedule will almost certainly allocate more money toward the interest early on in your loan. Take a look at your own schedule — or simply ask your lender — to see how your mortgage payments are structured and how your payments are split between principal and interest.
What else goes into your mortgage payment?
Principal and interest are your biggest expenses when paying your mortgage, but they’re not the only costs to consider. Depending on your specific circumstances, you could shell out a lot more money on these other housing costs:
- Property taxes: Your property taxes vary by state, county, property type and lot size. Even moving within your neighborhood — say from a small condo to a single-family house — could significantly impact how much you owe.
- Homeowners insurance: Every borrower needs to show proof of homeowners insurance before a mortgage lender will approve a loan. Like property taxes, your insurance premiums will depend on a wide range of factors, including the age of the home, proximity to flood zones and your claim history.
- Flood insurance: If your property sits on top of a flood zone, your lender will require flood insurance to cover the cost to repair any structural damage or even replace the home entirely. Checking for flood risks is a routine part of the mortgage process, and your lender will notify you if purchasing additional flood insurance is necessary.
- Private mortgage insurance: Despite what you may have heard, you don’t need to make a 20% down payment to qualify for a mortgage. There are a lot of down payment options out there for homebuyers, especially if you use government-insured loans like FHA mortgages. But you’ll likely need to pay private mortgage insurance, or PMI, if you pay less than 20% up front. That monthly charge will go away once you’ve built enough equity into your new home — at least with conventional mortgages like 30-year fixed rate loans. That’s not the case with FHA loans, though. PMI sticks with FHA loans through the entire loan term. You can only get rid of it by refinancing into a conventional mortgage once you have enough equity built up.
Can you pay off principal before interest?
As we noted earlier, mortgage lenders lay out amortization schedules so interest is paid in arrears. That means the interest due each month is based on the outstanding principal from the previous month. This helps lenders turn a profit more quickly on a loan, which gives them the financial liquidity and flexibility to extend more mortgages to more people.
It’s unlikely you’ll be able to convince your lender to flip your amortization schedule and earmark a larger portion of your mortgage payment to your principal. But, what you can do is make extra payments on your mortgage each month. Unless you have late fees to cover first, any extra money you put toward your mortgage will be applied to the principal. That’s not all: Because interest is paid in arrears, you’ll wind up owing less on interest the following month.
By doing so, you can meet your interest payment obligations while building equity in your home faster than you would under your original loan terms. Balancing your housing costs with other important items in your household’s budget — like, say, groceries and car loans — isn’t always easy. When in doubt, use an extra payments calculator to see if dedicating more funds to your mortgage makes sense given your financial situation.
Principal and interest make up the largest portion of your monthly mortgage payments. Money going toward your principal repays the loan itself, while interest is the cost you pay to borrow from a lender. You should also be aware that there are other expenses that go into your mortgage, including homeowners insurance and property taxes.
Calculating your principal and interest is key to understanding how much you need to spend each month on your housing costs. When buying a house, create a homebuying budget so you can comfortably make your mortgage payments while still setting aside enough money for your other important expenses. Your home should work for you, not the other way around.