Understanding Your Monthly Mortgage Loan Payments
Knowledge is power. This philosophy also applies to your mortgage loan payments.
This article will dissect the monthly mortgage loan principal and interest (P & I) payments. The intent is to provide a clearer understanding of how they work. Afterwards, you will also learn how to use that knowledge about your mortgage loan payments to save thousands of dollars.
Mortgage payments are amortized payments. As such, they cannot be calculated by simply multiplying the principal times the interest rate.
A quick way to calculate your monthly payment would be to use the mortgage calculator in the sidebar on the right. This article will break it down into greater detail — for borrowers who really want to understand what’s involved with their mortgage loan payments.
For your convenience, this section has been divided into three areas of concern:
- Amortization of mortgage payments.
- Prepayments and biweekly payments save you money.
- Adjustable-rate mortgage (ARM) loan payments are slightly different.
Amortization of Mortgage Payments
The schedule of payments required to both reduce the mortgage balance and pay all interest due is called the amortization. Ironically, the words mortgage and amortization are both derived from the French and Latin word morte, which means death.
As mentioned earlier, you cannot calculate the principal and interest (P & I) payment by simply multiplying the interest by the loan amount. It doesn’t work that way.
The monthly payment is calculated with three basic elements:
- Loan principal balance.
- Interest rate.
- Number of periods for amortization.
The mathematical formula for calculating your mortgage payment is
MP = LB [ (I (1+ I)n)¸((1+I)n - 1)]
The variable “MP” is the monthly payment, “LB” is the loan balance, “I” is the monthly (annual¸12) interest rate and “n” is the number of periods for the amortization.
There are three important points to take from this formula:
- Interest related to balance. The interest due with each payment is based on the loan balance for that payment.
- Decreasing balance. The loan balance is usually decreasing with each payment. The rate of this decrease starts slowly but gets faster with each payment.
- Increasing principal payment. As the loan balance decreases, so does the portion of each payment that goes towards interest. This means that more of the payments go toward the principal.
Amortization table
Your mortgage lender will usually provide you with an amortization schedule at the time you close your refinance or purchase mortgage loan.
The amortization table reviews the principal and interest payments for the entire term.
The amortization table contains at least these five important columns:
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- Payment number. With a 30-year loan, there are 360 monthly payments.
- Payment amount. This shows the total monthly principal and interest (P&I) payments for each of the payments.
- Principal portion of payment. In the beginning, only a small portion of the payment goes toward the principal balance. However, at the end of the loan term, the opposite bulk of the monthly payment goes toward the principal balance.
- Interest portion of payment. In the beginning, the bulk of the monthly payment goes toward the interest due on the current balance. However, at the end of the loan term, only a small portion of the payment goes toward interest.
- Current balance. This column provides the current balance remaining after each payment and should show it decreasing after each monthly payment.
Prepayment & Biweekly Payments Can Save Money
If you had a $100,000 30-year fixed-rate loan at a 7.50% interest rate you can pay it off in 20 years (instead of 30) and save $50,000 over the life of the loan — just by paying an extra $100 per month toward principal.
With that in mind, should you prepay your mortgage when possible?
It depends. If you plan to keep the property for the long-term or you are nearing retirement age, it’s probably a good idea. This goes back to the concept that a mortgage is an investment. As with most long-term investment, the more you can add to your periodic payments, the faster your investment will grow.
However, prepayments are not such a good idea in the following situations:
- Depressed area. If the property is in a depressed area, making prepayments is actually like buying a falling stock. You’re better off putting that money elsewhere.
- Low interest rate. If the loan’s interest rate is low or competitive, you should consider putting the money elsewhere.
- Better alternatives. If you have better investment options into which you can put the prepayment amounts, you should.
Nevertheless, during solid economic times, principal prepayments are probably the best way to save money on your mortgage loan payments. As you make your prepayments, we recommend the following steps:
- Separate check. Do not include your extra payment with your regular mortgage payments. The lender may inadvertently count the extra payment as part of next month’s regular payment, instead of lowering the principal balance.
- Indicate “payment toward principal” on check. This goes along with the preceding recommendation. Some loan servicing departments make mistakes; indicating this note clearly on the check will minimize the chances for such mistakes.
- Check off “extra principal payment” on coupon. Many lenders will have a box to check off on the coupon page or billing statement, to indicate whether you are making any prepayments. If so, remember to mark this option.
Biweekly Payments
The biweekly payment schedule replaces the monthly payment with half (1/2) of the regular monthly payment every two weeks.
However, because there are 52 weeks—or 26 bi-weeks—in a year, you end up paying the equivalent of 13 monthly payments each year. In other words, you make an extra payment each year.
If done correctly, the biweekly loan can cut up to five years off the standard 30-year loan. You will pay off the loan within 25 years and save five years’ worth of interest charges.
Many lenders offer borrowers the option to convert to a biweekly payment schedule. If your lender does not, you can actually set it up yourself by simply making an extra payment toward the principal each year.
Borrowers should try to avoid most third-party companies offering biweekly options.
They basically do what borrowers can do on their own; and these companies charge a hefty fee for their services.
These companies require an initial deposit of two-to-three months of mortgage payments from you. They then collect payments every two weeks from you. These companies then make monthly payments to the lender, as normally scheduled. However, every year they make an additional 13th monthly payment to the lender to achieve the savings of the biweekly plan.
Some of these companies have gone bankrupt, taking borrower deposits with them and jeopardizing their payment schedule — and credit ratings.
Prepayment Penalty
Some loan programs limit and sometimes do not allow prepayments. This is actually the case with most commercial loans.
Residential loans that have prepayment penalties normally do allow minimal prepayments, up to 2%-5% of the loan balance. Also, the prepayment penalties are only in effect for the first three-to-five years of the loan.
Most conforming loans do NOT allow prepayment penalties. Most lenders avoid prepayment penalties altogether, except for ARM loans with low teaser rates. Some states, such as Illinois, do not allow prepayments on most residential mortgage loans.
Adjustable-Rate Mortgage (ARM) Loans
Mortgage payment calculations for ARM loans are slightly different from fixed-rate loans, because the ARM loan’s interest rate changes.
The basic elements are the same, in that the mortgage payment is based on the loan balance, interest rate and number of amortization months. At the end of the term, usually 30 years, the loan’s principal balance and all interest due will be paid off.
However, ARM loans must take into account the changing interest rate. Whenever the rate changes, the ARM loan must recalculate the monthly payment.
The following example is for a 1-year ARM loan, with a 30-year term. This means that the loan is meant to be paid off in 30 years. However, the interest rate will change every year, on the anniversary date of the loan.
- First year. The payments for the first year is calculated similar to a fixed-rate loan, based on the starting rate, 360 months (30 years) and beginning loan balance.
- Second year. The interest rate is adjusted. The monthly payment for the second year is based on this new rate, the current mortgage balance and 29 years (348 months). [Note the lowered term.]
- Third year. The interest rate is again adjusted. The monthly payment for the third year is based on this new rate, the current mortgage balance and 28 years (336 months).
- Subsequent years. With each rate change, the monthly payment is recalculated with the new rate, current mortgage balance and shortened amortization—the basic idea remains that the loan’s principal and all interest due are paid within the standard 30-year period.
Negative amortization
Some ARM loans with attractive payment caps pose the danger of negative amortization. The term negative amortization applies to the situation in which the loan’s principal balance is actually going up instead of going down.
Most ARM loan programs do have caps on how much the interest rate can adjust. However, some ARM loans also have payment caps, which limit how much the monthly payment can increase. Payment caps often result in negative amortization, especially in the beginning years:
Because of the caps, the new payments are sometimes not enough to cover all of the interest due.
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- Any unpaid interest is added to the mortgage balance.
- Thus, the principal is actually increasing.
- Worst of all, you will be charged interest on the unpaid interest.
Many of these “payment cap” programs are attractive and can be advantageous. But, you must remain aware of how negative amortization works.
Go to next HomeBuyer Guide chapter: “19. Insurance Review— Your Insurance Requirements”
