A friend of mine asked me over the weekend how does mortgage interest work? His colleague had asked him a similar question, and he was passing it on to me.
At first, I didn’t know how to answer the question as it was quite broad. I said what do you mean by that?
That said, if you have a 3% rate and a loan amount of $1 million, does that equal $30,000 in interest?
Wishful thinking, isn’t it? i explained to him mortgage rate Should be viewed as annual interest rates.
Long story short, you pay a lot more than the interest rate on the loan because the interest rate is paid annually for 30 years in most cases.
View mortgage rates as annual interest charges
A better way to understand how mortgage interest works is to consider the mortgage rate on an annualized basis.
So if your 30-year fixed mortgage rate is 5% and your loan amount is $500,000, you’ll pay about $25,000 in interest the first year.
Note that I said first year and tentative, This is a rough estimate because the loan amount is not fixed.
Every month, you pay a portion of the interest and a portion of the principal. Thus, your outstanding loan balance gets reduced with each payment.
This means that less interest is payable on subsequent monthly payments, and because mortgages are amortized (Same payment amount each month), the payment structure changes.
As each payment is made, less interest is due (thanks to the smaller loan balance), and more of your payment goes toward the principal balance instead.
Using our example, you would have a monthly principal and interest payment of $2,684.11.
The first payment will consist of $2,083.33 in interest and $600.78 in principal.
If you multiply $2,083.33 by 12 (months), you get $25,000, which is the 5% interest rate applicable to the $500,000 loan amount.
That’s the easy part, and you can probably imagine how mortgage interest works.
Mortgage interest is reduced because payments are made each month
But remember that the loan amount is not constant, even if it is a monthly payment amount.
because $600.78 of that first mortgage payment was the principal, the loan balance is no longer $500,000.
It is now $499,399.22. It is a good thing. Your loan is being repaid even though it is still quite large.
For the second month, the same 5% interest rate is charged, but now based on the outstanding balance of $499,399.22.
If we do the math again, that’s $2,080.83 in interest, slightly less than the first month.
It’s still a 5% interest rate, but with smaller balances payable due to the smaller amount.
And because your mortgage payment amount is fixed, that means the remaining $2,684.11 goes toward principal.
This works out to $603.28 in principal being paid off in two months. It’s not a huge jump, but it’s an extra $2.50 going towards the original balance.
This also means that it is paying $2.50 less in interest. However, the interest rate is still 5%.
For a full year, you would actually pay $24,832.48 in interest. Not the full $25,000 because the loan amount was not $500,000 for the entire year.
It dropped every month as principal payments were made.
To see this better, consider the last mortgage payment
Hope my example that broke down the first year’s mortgage interest charges was helpful.
But why don’t we also look at the final mortgage payment to see where things end up.
Remember, this is the same monthly payment amount for the full 30 years, or 360 months on a 30-year fixed mortgage.
This means that payment #360 is still $2,684.11. And the interest rate is still, you guessed it, 5%!
However, the outstanding balance at the end of loan term is only $2,671.65. So using our same 5% interest rate, we would only pay $11.13 in interest for the final payment.
Remember, the 5% interest rate is based on the outstanding balance. And because most of the loan has already been repaid for 29 years and 11 months, there isn’t much left over.
The final payment is that $2,672.97 of principal remains, plus $11.14 in interest, which again totals $2,684.11.
Total mortgage interest paid over the entire loan term
Now we know that the 5% interest rate is compounded annually, and that’s about $25,000 over the course of just one year.
So how much is this when we look at all 30 years of the loan term, assuming it’s a 30 years fixed Kept till maturity?
Well it is a big number. We’re talking over $466,000, which is almost the same as the original loan amount.
This puts the total interest as a percentage of the principal at around 93.25%. In other words, you would have paid almost 93% of the principal amount borrowed as interest alone.
In total, you would have paid about $966,000, almost a million dollars, to pay off a $500,000 mortgage.
This is where the anti-loan, anti-mortgage people get fired up because they argue that the 5% mortgage rate is not realistic.
Instead, it’s a 93% interest rate, or something. But really, it’s just math, and how any loan works that you hold for a long period of time.
Mortgage interest is paid annually over decades, so the total amount of interest will be very high.
If you don’t like it, you’re always free to pay off your mortgage fasterIf you have the ability to do so.
But perhaps your money is better served elsewhere, especially if you’ve got a fixed interest rate of 2-3% for the next 20-years.