One of the most frustrating aspects of paying down a mortgage is watching the principal owed fall at a slow rate.
The reason that your mortgage balance is reduced at such a slow rate has to do with the fact that a mortgage is often paid out over the course of 30 years. Your mortgage is subject to an amortization process — the process that counts down what you owe over the course of time.
Mortgage amortization involves understanding how much of your payment each month goes toward the interest on your loan, and how much of it is going toward principal. Your total loan repayment is figured at the beginning of your loan, taking into account the compound interest you pay on your loan over time. Interest is compounded monthly for 30 years, on your total loan balance. That total amount is then divided by the appropriate number of months to determine your monthly payment, which consists of interest and principal.
At the outset of your loan, most of your mortgage payment goes toward the interest you owe. As you pay down the loan, though, the amount you pay in interest is reduced along with the balance, and toward the end of the mortgage term, most of your payment goes toward the principal.
How Mortgage Amortization Accounting Works
Let’s assume that you borrow $180,000 for a home, and your mortgage rate is 4.25%. Your monthly mortgage payment would be $885.49. Mortgage payments are generally due on the first day of each month. Normally, a lender offers a “grace period” of 15 days, so you can usually arrange to make your payment anytime in those first 15 days and have your loan payment treated as though you paid on the first day.
Your interest payment for each month uses a portion of of your annual rate. So, in our example, your monthly interest charge is 4.25/12, or about 0.35%. Each month, your balance is multiplied by that 0.35%. So, for the first month, the interest due is $180,000 x 0.0035 = $637.50. Subtract that amount from your total payment, and you see that $247.99 goes toward the principal, reducing your balance to $179.752.01.
The next month, that 0.35% will be multiplied by the new balance total, which means that your interest paid will be $636.62, and your principal will be reduced by $248.87. It’s not a big change from month to month, but remember that with a 30-year loan, you end up with 360 months, so this process is repeated that many times. By the time you make your final payment in our example, the interest portion will amount to $3.13, while the principal payment applied is $882.37, bringing your balance to zero.
You can speed up the process by making an extra principal payment on occasion each year, or by employing strategies, such as bi-weekly payments, to bring down the principal. You will still make the same mortgage payment each month, but since you reduce the principal, the interest charged the following month will be lower, which means there is a bigger principal payment. By adding an extra principal payment $100 per month, it is possible to reduce your mortgage term by about five and a half years in our example — and save $28,609.57 in total interest.
Why is My Monthly Payment Higher?
It’s important to understand that your monthly payment might be higher than you expect. In many cases, your homeowner’s insurance payment and property taxes will be included in that monthly payment. However, the amortization schedule doesn’t include these items, and you won’t pay interest on those amounts. Make sure you pay attention to your mortgage statements, as well as to statements from your escrow account. Payments for insurance and property taxes should be directed to the escrow account, and used appropriately, while principal and interest go to your mortgage account.
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