Mortgage Principal vs. Interest: What’s the Difference?

Many people aspire to own homes, and a mortgage is one of the best ways to do it. If you recently got a mortgage or want to learn more about how this financial product works, it’s important to know the difference between principal and interest payments. Knowing this distinction can get you out of debt faster and reduce your monthly payments.

What Is Mortgage Principal?

The mortgage principal is the loan’s balance. Assume a buyer puts $100,000 down for a $500,000 property. The mortgage addresses the $400,000 difference between your down payment and the house’s value. That difference is the mortgage’s principal. Every monthly mortgage payment reduces the principal until it becomes zero. At that point, you own the home free and clear. 

What Is Mortgage Interest?

Mortgage interest is the lender’s way of getting a return on their investment. You will have to pay interest on the balance. Many mortgages have monthly interest payments on top of monthly principal payments. However, some mortgages start with interest-only payments, and you only pay the principal after covering all of the interest payments. These loans are more suitable for house flippers and investors who want higher cash flow right now.

Lenders assign an interest rate based on your credit score, debt-to-income ratio, and other factors. A higher interest rate will increase the amount of interest you pay over the life of the mortgage.

How Is Interest Rate Calculated?

Calculating a mortgage’s interest rate is straightforward. All you have to do is divide the monthly interest payment by the monthly principal payment. If you pay $100 in interest and $1,000 for the principal each month, the mortgage has a 10% interest rate. 

You can also calculate the interest rate by dividing the annual interest payment by the annual principal payment. Using the same example but multiplying the numbers by 12, a $1,200 annual interest payment and a $12,000 annual principal payment still result in a 10% interest rate.

Interest Rate vs. APR

Interest rates reflect the cost of borrowing money. However, interest isn’t the only way a lender gets a return on investment. Banks charge additional fees each year that get lumped into the annual percentage rate (APR). This metric is a more accurate gauge of how much you will owe each year on top of your principal payments.

Other Inclusions in Your Monthly Payment

Interest is a big expense, but it’s not the only component of monthly mortgage payments. Depending on your home equity and other factors, these expenses may also show up.

Insurance

Mortgage lenders will require that you pay monthly insurance premiums if you have less than 20% equity in your home. You must request to cancel private mortgage insurance (PMI) payments if your home equity exceeds 20% for a conventional mortgage. Most lenders will not automatically do this for you. If you have a loan backed by the Federal Housing Administration (FHA), you will have to refinance the loan to stop paying insurance premiums once your home equity exceeds 20%.

Escrow

Lenders may ask for extra money if you have less than 20% equity in your home. This escrow will go toward insurance and property taxes. The bank acts as a middleman that ensures the money goes to the right places. Receiving this escrow reduces a bank’s risk because it knows some of the smaller but still essential expenses are getting covered. Escrow can help you avoid getting liens on your property.

Taxes

You will have to pay property taxes every year, even after you’ve paid off your mortgage balance. Property taxes vary in each state, but the one constant is that property taxes increase when your home gains value. 

How Amortization Works

Amortization alludes to how each monthly mortgage payment gets you closer to paying off your balance. Most of your initial monthly mortgage payments will go toward interest. If you have a $1,000 monthly mortgage payment, $700 may go toward interest during the first year. 

However, the interest percentage in your monthly mortgage payments gradually declines as you make more payments. By the fifth year, you may only pay $650 per month in interest and the other $350 per month in principal. 

Higher interest payments keep you in debt longer because you aren’t using those funds to reduce the principal balance. However, you can deduct those interest payments from your taxes. This tax deduction will be at its highest during the first year of homeownership. Then, you gradually have less interest to deduct thanks to the amortization schedule.

You can use this formula to calculate your monthly principal payment based on the amortization schedule:

Principal payment = Total monthly payment - [Loan balance x (Interest rate / 12)]

Assume the total monthly payment is $1,500 for a $150,000 loan with a 7% interest rate. Here’s how you would perform the calculation.

Principal payment = $1,500 - [$150,000 x (0.07/12) ]

Principal payment = $1,500 - $875

Principal payment = $625

At this point, less than half of the total monthly mortgage payment is reducing the balance. Making a separate payment toward the principal each month will trim your balance faster.

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Staying on Top of Your Mortgage

Paying the principal and interest each month will get you closer to owning your home free and clear. Once you pay off your obligation to the bank, you will only have to contend with property taxes moving forward. Paying off additional principal each month will reduce how much interest you owe and can get you out of debt sooner. 

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