Understanding Mortgage Interest

Mortgage interest is the interest you will pay to the lender for the amount you borrow to buy your home.   On a mortgage, the interest is figured on the principal, which is the loan amount still owed.  It is also heavily weighted toward the beginning of the loan.  You will pay far more interest than principal on early mortgage payments, with the balance slowly shifting over the length of the loan.  Lenders do this in order to earn as much interest as possible.  

Average Americans only stay in their homes for 5 to 7 years, so the lenders collect large chunks of the interest on entire 30 year loans in those periods.   For example, if you took out at mortgage for $100,000 at 6% interest, your very first payment would be $599.55.  $500 of that would be interest, and just $99.55 would go toward the principal.  If you continued to pay just the monthly amount of $599.55 over 30 years, you would end up paying $215,838.00 for your $100,000 house.  For calculations on different loan amounts, you can use an online calculator.    

Mortgages are paid off on an amortization schedule.  This means that you are paying interest on the remaining loan amount until that loan is paid off.  Because of this, if your mortgage allows it, making extra payments that pay down the principal directly can end up saving you a lot of money.   This is especially true for extra payments that are made early on, since mortgage interest is so weighted toward the first years of the loan.   On a typical loan, even at a relatively low interest rate, you will often pay as much or more in interest than you will in principal.  To figure out how much you are paying in interest over the total life of your mortgage, use an amortization calculator.  This tool will also often give you the amortization calendar of your loan, so you can see how much of your payment goes to interest and how much goes to principal over the years of the loan.  

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While it may seem like highway robbery to pay twice as much or more for your home then it is currently worth, you also need to consider that this system makes it far easier to get into your own home.  Prior to the 1930’s, you would have needed as much as 50% of the cost of the house in order to get a loan.  Today, 20% down is the accepted norm, but you can often get a mortgage with an even smaller down payment.  Also consider that home values trend upward over time.  So by the time you pay off your 30 year mortgage, your house may actually be worth what you paid for it, and you will be able to recover the full amount if you sell.  

Of course, in reality, very few people stay in their homes for that length of time, and if they do, they are not likely to sell it at any point.  Keep in mind that a house is a place to live, and not an investment. While mortgage interest drastically increases the cost of your home, the good news is that you can minimize its cost over time.  You can do this by paying extra down on your principal, and thus reducing the amount that interest is charged on.  

While you can make extra payments on your own, it is often difficult to set the money aside and to know exactly when and how much to pay extra. There are now software programs available to help you make these determinations.  These programs can look at your budget and show you how to leverage your income to pay down your mortgage as fast as possible.  While there is extra expense involved with using a software program to help you pay down your mortgage, it does make it easier and more efficient.  The savings from such a program should more than pay for it.  

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When looking to get a mortgage or to pay off your current mortgage, it is extremely important to understand the role mortgage interest plays.  Many people just look at the monthly payment and don’t consider how much of it is going toward interest and how much is actually going to pay off the house.   One strategy when figuring out how much you can afford on a monthly basis for a house is to back the number down by $100 per month.  If you can afford $1,000 per month, back it down to $900.  Find a house that you can get a mortgage for $900 per month.  Then consistently pay the full $1,000 per month.  You will pay down your principal much faster with this strategy.   If you can pay $1,000 per month over 30 years at 6% interest, you can afford a $166,000 house.  If you decide to pay only $900 per month over 30 years at the same rate, you can still get a $150,000 house.  In fact, you can probably negotiate a $166,000 house down to $150,000 and end up with the same house for $100 less per month.  And if you put that extra $100 toward the principal you will make serious progress toward paying off your house.  If you opt for the $166,000 house your first payment will be $995.  $165.25 will go toward principal, while $830 will go to interest.  If you decide on a $150,000 house, your first payment will be $899.  $149.33 would go toward principal and $750 to interest.  If you then pay the extra $100, you will pay $249.33 toward principal.  In the first scenario, only 17% of your first payment will go toward principal.  In scenario two, 28% will go toward principal.  

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If you have knowledge about how mortgage interest works and how it will effect the cost of your home, you can make better decisions on how much to borrow and how best to pay off your home.  Educate yourself on this issue, and you can save thousands, even tens of thousands.