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Mortgage Principal and Interest Explained

Mortgage Principal and Interest Explained

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Key Highlights

  • Understanding how mortgages work is essential in the process of purchasing a property. As we’re going to see, all mortgages are composed of 4 elements: principal, interest, taxes, and insurance. 
  • As the lender gives you the money to purchase your home, you agree to reimburse the full sum plus the interest over a set period of time.The interest is the fee the lender will charge you for the money necessary to buy a house.
  • Adding a little extra each month will shorten your mortgage plan and save tens of thousands of dollars in the long run.

What Is Your Principal Payment?

As soon as you start investigating how mortgages work, you’ll come across the term ‘principal’. The principal is the actual sum of money that is required to purchase a property. You’ll need to subtract the down payment from the seller’s price of the house and the difference owed to the seller is what is called our principal. Your monthly mortgage payments are essentially the principal plus the interest. 

What Is Your Interest Payment?

Another important component of your monthly payment is the interest payment. Unlike a classical loan from a bank where the interest is compounded with every payment, mortgages are compounded semi-annually, by law. As you start making payments towards your mortgage, most of the monthly payments will be made up of interest fees.
The type of interest rate will be determined by your mortgage lender, it can either be a fixed-rate or variable-rate. Use nesto’s online Mortgage Payment Calculator to calculate your monthly payments using different options/scenarios. 

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Mortgage Principal and Interest Example

Here’s an example of a $300,000 mortgage with a 10-year amortization on a 5% fixed rate. In this example, we’re only showing the total annual payments. Depending on the mortgage lender, you can opt for weekly, bi weekly or monthly payments. 

Yearly schedule

Year Beginning Balance Interest Principal Ending Balance
1 $300,000.00 $14,461.25 $23,722.39 $276,277.68
2 $276,277.68 $13,247.59 $24,936.05 $251,341.67
3 $251,341.67 $11,971.80 $26,211.84 $225,129.89
4 $225,129.89 $10,630.77 $27,552.87 $197,577.07
5 $197,577.07 $9,221.12 $28,962.52 $168,614.60
6 $168,614.60 $7,739.33 $30,444.31 $138,170.35
7 $138,170.35 $6,181.77 $32,001.87 $106,168.51
8 $106,168.51 $4,544.47 $33,639.17 $72,529.40
9 $72,529.40 $2,823.45 $35,360.19 $37,169.24
10 $37,169.24 $1,014.33 $37,169.31 $0.00

How Are Interest Rates Calculated?

Interest rates will vary from lender to lender and also from borrower to borrower. There are various factors that determine the interest rate that will be applicable to your mortgage. One of the most important factors is your credit score. If your score is high, you’ll get a better deal from the banks. 

If your score is low, you may want to build your score up before applying for a mortgage. A difference in interest rate of a couple of points will eventually amount to tens of thousands of dollars by the time you finish paying your mortgage. Interest rates are also determined by the current market and the type of loan you’ll sign.

Other Payments to Expect On a Typical Mortgage

On a typical mortgage there are some additional payments you’ll need to keep in mind beside the principal and the interest. Even if they make the bulk of your monthly payment, you’ll need to consider taxes and insurance. You may see it referred to as PITI. In this case, taxes refer to your property taxes and insurance refers to your home insurance to cover you in case of damages from events such as fires, break-ins, floods and electrical storms.

Adding Payments to Your Principal Balance

Mortgage amortization is how your mortgage repayments will be calculated for the period determined by your lender. This formula used by mortgage providers allows them to calculate the principal and the interest part of your monthly payment. However, it is a smart move, if you can afford it, to make additional payments towards your principal. Along with renegotiations of your interest rate with your lender, adding payments to your principal balance will mean that you’ll pay off your mortgage faster and save money on interest. 

FAQ

Here are some frequently asked questions about mortgage principal and interest.

 Is it smart to pay off interest or principal first?

Most of your payments will go towards the interest for the first few years of your mortgage. If you make additional payments early on, you’ll significantly reduce the interest owed and will shave many months from your initial mortgage plan. Additional payments will go towards your principal, your monthly payment plan will remain the same. So by paying a little as $50 or $100 extra each month, you will save a significant amount of money in interest over time and also reduce the number of years of your amortization period.

What happens if I pay the principal only?

Make sure to tell your mortgage provider that you want to make additional payments to your principal only. As we’ve seen above, any additional payments will significantly reduce the total amount of interest calculated and the number of years of repayments. In short, the faster you pay off your mortgage, the sooner you own your home.

Final Thoughts

Buying a home can be stressful so it’s important that you understand how a mortgage works, even if you plan to work with a mortgage broker to purchase your home in Canada. 

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