How mortgage interest works

Last update:  October 23, 2023

Summary

Mortgage interest probably works different from what you expect.  Here's the summary:

  • It's neither simple nor compound.
  • You pay interest every month as part of your mortgage payment.
  • For most of the life of your loan, most of your payment goes towards interest, rather than paying down the loan (except when the interest rate is very low).
  • As a result, 15 years into your 30-year loan, you haven't paid off half the loan, you've paid off only around 25%.

How it works

Let's say you borrowed $400,000 to buy a house at an interest rate of 8%, for 30 years.  To find the interest we owe for the first month, first we take 8% of the $450,000 balance, which is $36,000.  Then we divide by 12 because there are 12 months in a year, and you're paying interest only for that month.  So $36,000 ÷ 12 = $3000.  That's how much interest you pay in the first month.

The total payment on your loan is $3302, so $3000 goes towards interest, and only $302 goes towards principal.  So, you've paid down your loan by only a measly $302.  Your principal balance is now $450,000 - $302 = $449,698.

When the next month comes around you owe interest only on $the $449,698 outstanding balance.  Your interest in the second month is $449,698 x 8% ÷ 12 = $2998.  Your payment is $3302, so with $2998 going to interest, this month you pay down your loan by ($3302 - 2998 = ) $304.

Here's how it looks in table form:

Paying down a $450k, 30-year mortgage @ 8%

Month

Principal
Balance

Interest Paid
(Principal x
8% ÷ 12mos.)

Principal Paid Down
(Monthly Payment of $3302
  less Interest paid)

Percent of payment
going to interest

1

$450,000

$3000

$302

90.9%

2

$449,698

$2998

$304

90.8%

3

$449,394

$2996

$306

90.7%

4

$449,088

$2994

$308

90.7%

That's certainly depressing. After four monthly payments of $3302, you've paid $13,208 total, but you've only paid down your loan by $1220!

The only good part of this is that as time goes on, more and more of your payment goes to principal and less and less goes to interest. But most of your payment will go to interest for a very long time.  Here's what it looks like in graphical form, with a lower interest rate than the example above.


Percent of monthly payment that goes to interest, by year

30-year loan @ 7%

Notice that in year 15 when you're halfway through the term, 75% of each payment is just going to make the bank richer, and only one-fourth is actually paying down your balance and building equity.  Ouch!  You have to get all the way to year 22 before more of your payment goes towards principal than towards interest.

Here's the same concept, looked at from the other end.

Equity built by year

30-year loan @ 7%

After 15 years you don't own half your home. You own only about 25% of it. You don't own half of it until about year 22.

Is there any way to get a better deal?  Yes, there are two ways. Getting a 15-year loan, or making prepayments. So, moving on....

 

15-year loans save a bunch of interest

One way to save on interest is to get a mortgage with a 15-year term instead of a 30-year term.  While this saves interest, most people can't afford it, because the monthly payment is higher.  Here's how the loan we first looked at above would work at 15 years.

Paying down a $450k, 15-year mortgage @ 8%

Month

Principal
Balance

Interest Paid
(Principal x
8% ÷ 12mos.)

Principal Paid Down
(Monthly Payment of $4300
  less Interest paid)

Percent of payment
going to interest

1

$450,000

$3000

$1300

69.8%

2

$448,700

$2991

$1309

69.6%

3

$447,391

$2983

$1317

69.4%

4

$446,074

$2974

$1326

69.2%

The monthly payment on a 15-year mortgage is higher than for a 30-year mortgage, and the extra money pays the principal down faster. Since your outstanding debt is shrinking faster, there's not as much debt each month to pay interest on, so you pay much less interest over the term of the loan.

Here's a calculator showing the difference.

Loan amount

Interest rate

%

15-year
30-year

Monthly Payment
$
$

Total Paid
$
$

Total Interest Paid
$
$

Extra interest paid
  on a 30 vs. a 15
$

 

Making prepayments

You might not be able to qualify for a 15-year mortgage, since the payments are higher.  Or you might already have a house with a 30-year mortgage.  In these cases, if you can afford it, you can make extra payments on your principal each month, which pays off your house faster and saves on interest.  Just make sure that your mortgage agreement doesn't contain a prepayment penalty clause. (Most don't.)

How much should you prepay?  We cover that in our separate article about how to make prepayments.

 

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