Mortgage Q&A: “Why are mortgage payments mostly interest?”

Here’s an *interesting* mortgage question – pun intended.

## Payment Composition Over Time

- Most homeowners take out fixed-rate mortgages
- With monthly payments that don’t change over 30 years
- While the mortgage payment stays the same
- The amount that is allocated to principal and interest changes monthly

The way mortgages are set up here in the United States, each monthly payment is the same amount, assuming it’s a fully amortizing fixed-rate mortgage, which most tend to be.

This keeps housing payments more affordable (and predictable) because the balance is paid off evenly over a long period of time, such as 30 years.

However, even though the payment is fixed, the composition of the payment will change monthly until the loan term ends.

**Let’s take a look at an example to illustrate:**

Loan type: 30-year fixed mortgage

Loan amount: $200,000

Mortgage interest rate: 4%

In this common scenario, the monthly mortgage payment would be $954.83 for 360 months in a row. Ouch.

Each month, the borrower would need to make the same payment to the lender in order to satisfy the entire balance in 30 years.

The amount would never change, though as mentioned, the composition would. In fact, it would change every single month during the loan term.

## How Much Goes Where Each Month?

- During the early years of a home loan
- Most of the payment goes toward interest thanks to the large outstanding balance
- That shifts toward principal as the loan balance shrinks over time
- Unfortunately, most borrowers don’t keep their loans long enough to see it

As you can see from this image of the amortization schedule, the first monthly mortgage payment consists of $288.16 in principal and $666.67 in interest.

In short, the first payment on a mortgage is “mostly interest.” In fact, interest accounts for nearly 70% of the first payment. Boohoo.

In the second month, the payment is still $954.83, but the composition of the payment changes slightly. The principal portion increases to $289.12, while the interest portion drops to $665.71.

Why is this? Well, remember the first month’s principal payment of $288.16? That lowered the outstanding principal balance from $200,000 to $199,711.84.

As a result, the interest due on the second monthly payment dropped, and the principal increased, because as noted earlier, the payment amount stays constant.

Over time, this trend continues. The principal portion of the monthly mortgage payment increases while the interest portion drops.

It’s pretty minimal in the beginning because little principal is paid each month with such a large balance demanding so much interest each month.

This is the “front loaded” argument you here about – how interest makes up the lion’s share of early payments. It’s not a gimmick, just the way math works.

## Principal Surpasses Interest!

- It takes nearly half the loan term
- For principal payments to exceed interest payments
- But once this finally happens
- Payments become very principal-heavy and the loan balance is paid down fast

But in month 153, or nearly 13 years into a 30-year mortgage, the principal portion of the mortgage payment finally surpasses the interest portion.

As seen in the screenshot above, the principal portion of the monthly payment is $477.88, while the interest portion is $476.95, which still equals the original payment amount of $954.83.

Interestingly, the outstanding loan balance is still a hefty $142,608.40, or 71% of the original balance.

It’s not until month 231, or nearly 20 years into the loan term, that the outstanding balance falls below $100,000, or less than half of the original loan amount.

In other words, the bank still very much owns your home, even though you think you’re the king of your castle.

However, this is where the principal really starts to get paid down, as interest finally takes a back seat.

During the final year of the loan term, each monthly payment is more than 96% principal, with very little interest due because the outstanding balance is so low.

A small outstanding balance coupled with a low mortgage rate means associated interest will be pretty insignificant, as seen in the image above.

Assuming the loan is paid off in full, as scheduled, a borrower would pay a total of $343,739.21, of which $143,739.21 would be interest.

So it’s not mostly interest, rather mostly principal.

## The Real World Scenario

- Most homeowners sell or refinance in less than 10 years
- So for these borrowers their payments will be mostly interest
- But technically you pay more principal than interest
- If the home loan is held until maturity

In reality, many homeowners don’t hold their mortgages for the full term. In fact, most are said to hold their loans for a fraction of the loan term, such as seven or eight years.

That’s right – plenty of borrowers refinance, prepay the mortgage earlier, or simply sell their home and move on to another mortgage.

So it’s kind of misleading to look at mortgages as if they’re going to last the full term. But it’s for this very reason that mortgage payments tend to be mostly interest.

Because many borrowers never get to the point where the principal actually surpasses the interest.

When borrowers do refinance, critics will argue that they’re “resetting the clock,” which refers to extending the loan term and starting the process all over again.

For example, if you paid down your existing 30-year loan for 10 years, then refinanced into another 30-year loan, you’d extend the length of your mortgage.

Same loan amount, but longer time period to pay it off, even if your mortgage rate is lower.

As a result, your balance would be paid off over 40 years, as opposed to 30. That’s 10 years from the first loan and 30 years for the refinance loan, meaning it could result in more interest paid.

Again, most borrowers don’t hold their loans that long, so again this fear is overstated and probably not even relevant.

However, if you are deep into a 30-year mortgage and looking to take advantage of a lower mortgage rate, consider a shorter term as well, such as a 15-year mortgage.

That way you’ll avoid paying extra interest and stay on track to be free and clear on your home as originally intended, assuming that’s your intention.

Michael McKayJanuary 19, 2016 at 7:09 am -Hi Colin,

Thanks for the article! Very helpful! I have 22 years and 280,000 in principal left on my 30 year loan and I’m considering refinancing with a lower interest rate and with 22 years and 280,000. Would I be correct in thinking that I will pay less interest over the 22 years but might pay down less of my principal initially (due to returning to the interest dominant part of the amortisation process) than if I stayed with the current loan? I do have about $50,000 in savings which I’m going to add to the home loan either way. Does this have a greater impact if applied to a loan that is starting off as opposed to a loan that is 8 years in? Thank you for your insights!

Mike

Colin RobertsonJanuary 19, 2016 at 6:13 pm -Michael,

If you get a new 30-year loan then your payments will go mostly to interest again as opposed to refinancing into say a new 20-year term or 15-year term to stay the course. The further in you are the less interest you’re paying each month because the outstanding balance is lower and payments are fixed (if it’s a FRM). If you get a new 30-year term that remaining debt is then spread out over another 30 years, which means even more interest.

Scott TilgnerFebruary 28, 2016 at 4:42 pm -Colin,

What are your thoughts on paying extra into the principal on a mortgage? I have no idea where my future will take me and my family, and I am only 2 years into my mortgage, however, I have been consistently putting in an additional 10-15% on each payment towards the principal as an investment. What are your thoughts on this? Thanks.

Colin RobertsonFebruary 28, 2016 at 9:09 pm -Scott,

It’s really personal preference, and there are certainly worse things one can do with their money. By paying extra, you’re more or less getting whatever the mortgage rate is as your return on investment. So if that money is better off paying down the mortgage as opposed to sitting in a savings account earning less than 1%, it can make sense. The downside is that a home is illiquid, so getting that money back can be more burdensome. Some folks like to pay as much as possible, some prefer to put their extra cash elsewhere because they think they can get a better return or they simply don’t want it all tied up in their home, and others pay a little extra to fall somewhere in between.

WillApril 4, 2016 at 11:12 am -Great explanation. This issue is very confusing for many people! I have found that a good way to explain it is to start with a super simple loan a friend might give you:

“Here’s $1000. You owe me that money back plus 10% interest in 1 year”

Then analyze the difference when you start adding monthly payments, and consider why the interest goes down over time.

I made a video to try to explain it!

Vicki ConstancioJuly 21, 2016 at 10:37 am -Then what is advantage to paying off loan early? Early payoff calculator showed I owed 28k, but BOA said 49k when I went to pay off home. Felt cheated out of 20k

Colin RobertsonJuly 21, 2016 at 1:11 pm -Vicki,

Not sure what your situation is, can you clarify?

james chippersAugust 31, 2016 at 1:33 pm -Its a scam. That’s all home loans are…they’re designed to make profits off of hardworking people and keep them in debt. That’s why this is all driveled up rules of paying interests….kind of like, how interested are you in keeping your home? Wanna play? This is exactly why the U.S. home ownership is declining and more Americans are working into their mid 70’s is their brainwashed and complacent into thinking they are paying off their mortgage for real home ownership when in fact it really is feudalism all over again.

Dan FrenchMarch 14, 2017 at 5:35 pm -Another way of looking at it is, during those first twelve payments, the real interest rate you’re paying is about 69% and very slowly goes down each year. Since a lot of people sell their homes after, say, fifteen years or less, the effective rate they paid was more like 40-50%, but boy, did they feel good about getting that 4% rate when they took out the loan!

ChuckApril 28, 2017 at 8:35 am -we agreed to 4 % on 130K loan paid 70K down title etc- 8 years- sold the house- loan payoff-129K– after 81K in payments–why did the 30 year interest rate remain when the term was changed to 8 year payoff? Why

Colin RobertsonMay 1, 2017 at 11:32 am -Was it an interest-only loan is the balance didn’t change over 8 years?