Learn how monthly mortgage amortization works
How mortgage payments are calculated is a mystery for most home buyers and even for many Realtors and loan officers. The reason it is a mystery is because the formula to calculate the monthly payment for an amortizing mortgage is the following:
To calculate the fixed monthly payment (P) required to fully amortize a loan of M dollars over a term of n months at a monthly interest rate of i. (e.g. If your mortgage rate 6%, i is .06/12 or .005).
P = M[i(1 + i)n]/[(1 + i)n - 1]
Most people's eyes start glazing over right after the equals sign, but the formula is not as complicated as it looks. The formula calculates what payment is required to repay your loan balance and the interest due on that balance over the term of your loan. It is designed to take into account the fact that every month a small amount of principal is paid off so there is slightly less interest due on the remaining principal balance.
The benefit of an amortizing loan is that you pay less interest than you would if you just borrowed the entire amount for 30 years and then paid it back. For example, the total payments on a $100,000 amortizing loan at 6% for 30 years add up to $215,838 including principal and interest repayment. If you borrower $100,000 for 30 years interest only and pay $100,000 at the end, your total payments would be $280,000.
With an amortizing loan, every month when you make a payment you pay interest and a small amount of principal in the early years. Every principal payment reduces the amount of interest due because you have already paid back that principal and no more interest is due on it.
For example, if your first mortgage payment is $599.55 for a 30 year fixed rate loan of $100,000 at 6%, your first payment is made up of $500 in interest and $99.55 in principal. The first monthly payment is calculated by figuring out the interest for that month on that principal balance and then having the remainder reduce the principal.
So in this example, the annual interest on $100,000 at 6% is $6,000 or $500 per month. So just for that first month, when the principal is $100,000, the $599.55 payment is made up of $500 in interest. For the second month, your principal balance has been reduced to $99,900.45, so that 6% interest is only due for the month on that slightly smaller balance. Your second payment of $599.55 will include $499.51 of interest and $100.49 of principal.
Over the course of 360 payments, the amount of interest paid reduces every month and the amount of principal paid increases every month until the last payment. Your monthly payment will always stay the same.
Interest Only Loans
Some borrowers have interest only mortgage payments which are much easier to calculate. The following formula calculates an interest only monthly mortgage payment:
Monthly Interest Only Mortgage Payment = (Loan Amount x Interest Rate ) / 12
For example, if you borrow $200,000 at a 6% interest rate, the annual interest would be $12,000 and when you divide by 12 you get the monthly mortgage payment of $1,000.
Interest only loans fell into disfavor during the mortgage credit crisis of the past few years because the loans were perceived as riskier than fully amortizing loans. Borrowers just need to know that when they get an interest only mortgage that they are not paying off any principal. While it is tempting to take the lower payment of an interest only mortgage, they are only advisable if borrowers anticipate additional income in the future to help reduce the principal balance over time.
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