Principal and interest are the two primary components of a mortgage payment. Aside from any necessary fees involved, the principal and interest make up for all the money going out when paying back your mortgage. In its simplest definition, the principal is that directly contributes to you paying back your initial loan. Interest, on the other hand, is money that is paid to the lender and does not help reduce your loan amount. Simple enough?
To make things a bit trickier, “compounding interest,” which is what most mortgages entails, calculates the interest rate depending on how many years you have left on your mortgage. Let’s use an example to describe it better.
If a young couple were to purchase their very first home, let’s say $500,000 for example, and they had a $100,000 down payment, their mortgage would be $400,000. If they had today’s interest rates, their mortgage would be around 3%, compounded semi-annually, over 25 years with their interest rate re-negotiable every 5-years if they keep the same term. Assuming they were able to get 3% for the entire 25-years, their monthly payments would be $1,892.98 a month for the life of their mortgage.
However, their first payment would not be $1,892.98 with 97% of it going to paying down the $400,000 balance and 3% going towards interest. Because the interest is based directly on the mortgage amount, the payment would be broken down as $993.81 of interest and $899.17 going towards paying down the principal balance of $400,000.
Now, that payment amount won’t stay like this forever. The very last payment before the first 5-year term is up would be broken down as $854.62 going towards interest and $1,038.36 of the $1,892.98 going towards paying down the principal. It wouldn’t be until year 10 where the interest portion dips below $500.
A Couple Of Tips
If you can, any pre-payments you make each month will directly pay down the principal balance outstanding. This will also in turn, allow for less interest to be charged as interest is always calculated based on the current balance outstanding. In the later years, it may not be as advantageous, but in the first 5-10 years, it can be extremely beneficial.
One side note – if you are ever given the option to choose, always pay off your principal balance before tackling the interest portion. While this would likely not be an option when opting for a mortgage, it may be offered to you in other circumstances that involves financing.
If you want to see the break down of principal and interest portions inside your own mortgage, feel free to reach out to a Leap Financial mortgage specialist – we’ll be happy to go over it with you in detail.