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How Mortgage Loans Work

How Mortgage Loans Work

Excluding property taxes and insurance, a traditional fixed-rate mortgage payment consist of two parts: (1) interest on the loan and (2) payment towards the principal, or unpaid balance of the loan.

Many people are surprised to learn, however, that the amount you pay towards interest and principal varies dramatically over time. This is because mortgage loans work in such a way that the early payments are primarily in interest, and the later payments are primarily towards the principal.

In the beginning... you pay interest
To help calculate monthly payments for loans based on different interest rates, lenders long ago developed what are known as "amortization tables." These tables also make it fairly easy to calculate how much money of each payment is interest, and how much goes towards the principal balance.

For example, let's calculate the principle and interest for the very first monthly payment of a 30-year, $100,000 mortgage loan at 7.5 percent interest. According to the amortization tables, the monthly payment on this loan is fixed at $699.21.

The first step is to calculate the annual interest by multiplying $100,000 x .075 (7.5 %). This equals $7,500, which we then divide by 12 (for the number of months in a year), which equals $625.

If you subtract $625 from the monthly payment of $699.21, we see that:

  • $625 of the first payment is interest
  • $74.21 of the first payment goes towards the principal

Next, if we subtract $74.21 (the first principal payment) from the $100,000 of the loan, we come up with a new unpaid principal balance of $99,925.79. To determine the next month's principal and interest payments, we just repeat the steps already described.

Thus, we now multiply the new principal balance (99,925.79) times the interest rate (7.5%) to get an annual interest payment of $7,494.43. Divided by 12, this equals $624.54. So during the second month's payment:

  • $624.54 is interest
  • $74.67 goes towards the principal.

Note: In Canada, payments are compounded semi-annually instead of monthly.

Equity
As you can see from the above example, even though you pay a lot of interest up front, you're also slowly paying down the overall debt. This is known as building equity. Thus, even if you sell a house before the loan is paid in full, you only have to pay off the unpaid principal balance--the difference between the sales price and the unpaid principle is your equity.

In order to build equity faster--as well as save money on interest payments--some homeowners choose loans with faster repayment schedules (such as a 15-year loan).

Time versus savings
To help illustrate how this works, consider our previous example of a $100,000 loan at 7.5 percent interest. The monthly payment is around $700, which over 30 years adds up to $252,000. In other words, over the life of the loan you would pay $152,000 just in interest.

With the aggressive repayment schedule of a 15-year loan, however, the monthly payment jumps to $927-for a total of $166,860 over the life of the loan. Obviously, the monthly payments are more than they would be for a 30-year mortgage, but over the life of the loan you would save more than $85,000 in interest.

Bear in mind that shorter term loans are not the right answer for everyone, so make sure to ask your lender or real estate agent about what loan makes the best sense for your individual situation.

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Learn more about Columbus and Central Ohio Home Communities, school districts, price ranges, and taxes.

Bexley Homes - Bexley is a city in Franklin County, Ohio, United States. Incorporated as a village in 1908, Bexley is an old tree-lined suburb of Ohio's capital, Columbus, located on the banks of Alum Creek right next to Driving Park.
Canal Winchester Homes - Canal Winchester is a village in Fairfield and Franklin counties in the U.S. state of Ohio. The population was 4,478 at the 2000 census.
Columbus Homes - Columbus is the capital and the largest city of the U.S. state of Ohio. Located near the geographic center of the state, Columbus is the county seat of Franklin County, although parts of the city also extend into Delaware and Fairfield counties.
Delaware Homes - Delaware is a city in the U.S. state of Ohio and the county seat of Delaware County.
Dublin Homes - Dublin is a city in Franklin, Delaware, and Union counties in the U.S. state of Ohio. The population was 31,392 at the 2000 census. In 2007, the population was estimated to be 37,954, and Dublin continues to be one of the fastest-growing suburbs of Columbus.
Gahanna Homes - Gahanna is a city in Franklin County, Ohio, United States. The population was 32,636 at the 2000 census.
Grandview Heights Homes - Grandview Heights is a city in Franklin County, Ohio, United States. The population was 6,695 at the 2000 census.
Granville Homes - Granville is a village in Licking County, Ohio, United States, founded by settlers from Granville, Massachusetts, a town of which it now has three times the population.
Grove City Homes - Grove City, founded in 1852, is a city in Franklin County, Ohio, United States. The population was 27,075 at the 2000 census. It is a suburb of Columbus.
Groveport Homes - Groveport is a village in Franklin County, Ohio, United States. The population was 3,865 at the 2000 census, and estimated to be 4,926 as of July 2006.
Hilliard Homes - Hilliard is a city in Franklin County, Ohio, United States. The population was 24,230 at the 2000 census. Hilliard's population was estimated to be 26,656 in 2005, and the city continues to grow.
Lewis Center Homes - Lewis Center is an unincorporated community in northwestern Orange Township, Delaware County, Ohio, United States, located between Columbus and Delaware.
New Albany Homes - New Albany is a village in Franklin and Licking Counties in the U.S. state of Ohio, just northeast of the state capital of Columbus.
Pataskala Homes - Pataskala is a city in Licking County, Ohio, United States. The population was 10,249 at the 2000 census; a 2006 estimate reported a population of 12,643.
Pickerington Homes - Pickerington is a city situated in Fairfield and Franklin counties in the central region of the U.S. state of Ohio.
Powell Homes - Powell is a city in Delaware County, Ohio, United States. The population was 6,247 at the 2000 census.
Reynoldsburg Homes - Reynoldsburg is a city in Fairfield, Franklin, and Licking counties in the U.S. state of Ohio.
Sunbury Homes - Sunbury is a village in Delaware County, Ohio, United States. The population was 2,630 at the 2000 census, and estimated to be 3,252 as of July 1, 2006.
Upper Arlington Homes - Upper Arlington is a suburban city in Franklin County, Ohio, United States, on the northwest side of the Columbus metropolitan area.
Westerville Homes - Westerville is a city in Franklin and Delaware Counties in the U.S. state of Ohio. It is a suburb of Columbus. The population was 35,318 at the 2000 census.
Worthington Homes - Worthington is a city in Franklin County, Ohio, United States. The population was 14,125 at the 2000 census.


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