Is it better to pay off interest or principal

Homeownership is a dream for many people. But let's face it, buying a home isn't cheap. It requires a significant amount of money that most of us will never be able to put down. That's why we rely on mortgage financing. Mortgages allow consumers to purchase properties and pay for them over time. The mortgage payment system, though, isn't one that a lot of people understand.

Your mortgage loan is amortized. which means it is stretched out over a predetermined length of time through regular mortgage payments. Once that period is over—say, after a 30-year amortization period—your mortgage is completely paid off and the house is yours. Each payment you make represents a combination of interest and principal repayment. The proportion of interest to principal changes over the life of the mortgage. What you may not know is that the majority of your payment pays a larger proportion of interest in the earlier stages of your loan. Here's how it all works.

Key Takeaways

• Mortgages work on an amortization schedule, which is the length of time it takes to pay off the loan.
• A typical mortgage payment consists of both interest and repayment of principal.
• As more of your principal is repaid, the less interest you owe on your mortgage.
• Monthly payments remain the same for the life of the loan for traditional fixed-rate loans, but the portion that goes toward interest will decline while the principal portion increases.
• Making prepayments toward your principal balance reduces the amount of interest you pay but only if it makes financial sense and if there are no prepayment penalties.

How Does Mortgage Interest Work?

Mortgage interest is the interest you pay on your home loan. It is based on the interest rate agreed to at the time you sign your contract. The interest compounds, which means the balance of your loan is based on the principal plus any accumulated interest. Rates can be fixed, which remain steady during the length of your mortgage, or variable, which are adjusted at various periods based on market rate fluctuations.

Your mortgage payment primarily goes toward interest in the initial stage, with a small amount of principal included. As the months and years go by, the principal portion of the payment steadily increases while the interest portion drops. That's because the interest is based on the outstanding balance of the mortgage at any given time, and the balance decreases as more principal is repaid. The smaller the mortgage principal, the less interest you'll be paying.

You can expect to pay as much as 50% of the mortgage in interest. The point at which you begin paying more principal than interest is known as the tipping point. This period of your loan depends on your interest rate and your loan term. So someone with a 30-year loan at a fixed rate of 4% will hit their tipping point more than 12 years into their loan. Having a lower rate will get them to this point faster.

This process is known as amortization. When you take out a mortgage, your lender can provide you with an amortization schedule, showing the breakdown of interest and principal for every monthly payment, from the first to the last.

Your monthly payments remain the same for the life of the loan with a traditional, fixed-rate mortgage, which may have a term of 10, 20, or 30 years.

Example of Mortgage Interest Over Time

To illustrate how amortization works, consider the following:

• A traditional, fixed-rate mortgage for $100,000
• An annual interest rate of 2%
• A time to maturity of 30 years

The monthly mortgage payment would be fixed at $369.62. Here's how they'd be structured:

• The first payment would include an interest charge of $166.67 and a principal repayment of $202.95. The outstanding mortgage balance after this payment would be $99,797.05.
• The next payment would be equal to the first ($369.62) but with a different proportion going to interest and principal. The interest charge for the second payment would be $166.33, while $203.29 will go toward the principal.

By the time of the last payment, 30 years later, the breakdown would be $369 for principal and 62 cents for interest.

Special Considerations

The example above applies to a basic, fixed-rate loan. But how does the situation work if you have a different kind of mortgage loan?

If you have a variable- or adjustable-rate mortgage, it is also likely to apply a greater portion of your monthly payment to interest at the outset and a smaller portion as time goes on. However, your monthly payments will also adjust periodically, based on prevailing interest rates and the terms of your loan.

There is also a less common type of mortgage, called an interest-only mortgage, in which the entirety of your payment goes toward interest for a certain period of time, with none going toward principal. The borrower is responsible to repay the principal balance only after a certain amount of time in a lump sum.

Paying Down More Principal

As noted above, the time when you start paying more in principal is called the tipping point. The interest portion starts to drop with every subsequent payment. And it can take years for you to get to that point.

Since the amount of interest you pay depends on the principal balance, you can reduce the total interest on your loan by making larger principal payments as you pay down the loan. You can do this by making a single lump-sum payment, which is normally called a prepayment, or by putting some additional money on top of your regular mortgage payment.

Let's say your payment is $500 per month. your payments are $6,000 for the year. Adding an additional $100 for half the year means you're paying $6,600. That additional $600 ends up going to the principal balance.

While this may sound really good, the question remains: Should you pay down your mortgage with extra payments? That depends on your financial situation. It only really makes sense if you can truly afford it and if your income is enough to support an emergency fund and retirement account contributions among other things. After all, the money you use to pay down your mortgage is money that can be used elsewhere. And you'll want to make sure your lender doesn't charge you any prepayment penalties or fees.

What Is Mortgage Amortization?

Mortgage amortization is a term that refers to the length of time it would take to pay down the principal balance of a home loan with regular monthly payments. This is based on a period of time known as the amortization period. So a mortgage with a 30-year amortization period would take that long to pay off the principal balance.

How Do You Calculate a Mortgage Amortization Schedule?

A mortgage amortization schedule shows you how many payments you must make from the first payment to the last. Each payment is divided up between interest and principal. The formula to calculate the amortization schedule is Total Monthly Payment – [Outstanding Loan Balance x (Interest Rate / 12 Months)]. You can also use Investopedia's amortization calculator to see how much of your payments are divided up between interest and principal.

What Happens to Monthly Interest if I Pay Down Principal on My Mortgage?

Paying down the principal balance on your mortgage can effectively reduce the amount of interest you owe each month. The interest is based on the principal balance of your loan and since your overall balance decreases, the amount of interest also decreases.

Does Refinancing Lower My Interest Payments?

Many people refinance their mortgages in order to get better terms on their loan, such as a better interest rate or a better loan term. In some cases, they may be able to do both. Doing so may lower your monthly payment, which can cut the amount of interest you pay each month. You'll also see a drop in the total interest you'll pay over the length of your loan.

The Bottom Line

Buying a home and securing a loan are just part of the homeownership equation. Outside of these two factors, understanding how mortgage rates work and how your payments are divided up between the interest and principal is a key point to making you a more informed consumer.

You will pay more in interest in the early days of your mortgage, and that isn't unusual, especially when you consider how much interest you'll end up paying over the life of the loan. You may be able to reduce this amount by refinancing for a better rate and/or a better loan term. Or consider making prepayments to reduce your principal balance. Just make sure there are no penalties involved otherwise you could be losing out more than you think.

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