For those of you who have never purchased a home before, the term “interest rate” can sometimes make your eyes glaze over. Not to worry! I’m here to explain what this portion of your monthly mortgage payment actually means.
Your mortgage payment is made up of four parts sometimes referred to as PITI: principal (the amount that goes toward paying down your original loan amount), the interest, property taxes (if you chose to pay them with your mortgage), and private mortgage insurance (only if you’ve financed more than 80% of the value of the home). The interest is what lenders charge in exchange for giving you hundreds of thousands of dollars to purchase that dream home and what makes them a profit.
The interest rate that is quoted is a percentage of your loan amount that you’ll be paying in addition to paying back the loan. For instance, if your mortgage is $500,000 and your interest rate is 3.5%, then you’re going to be paying 3.5% of $500,000 ($17,500) each year in interest. So when you make your first mortgage payment, you’re (theoretically) paying 1/12th of $17,500, or $1,458.33, in interest. If your total mortgage payment is $2,500, then you’re paying $1,041.67 towards your loan balance.
Next month, your loan amount is $498,958.33, 3.5% of that is $17,463.54, and 1/12 of that is $1,455.30. So your second mortgage payment will pay $1,455.30 towards interest and the remainder ($1,044.70) towards principle. And so on and so on 358 more times until your principle balance is zero.
As you can tell, most of your money for the first several years will go toward interest instead of principal. Luckily (at least for now), there’s the mortgage interest deduction that takes some of the sting out of that realization. And the longer you own your home, the more principal you pay, the less interest, and the greater equity you accrue. Thus the magic of home ownership.
Does that sound daunting? Don’t worry. I know some excellent lenders who can not only pre-approve you for a loan, but also educate and consult you on the entire process.