Mortgages allow consumers to purchase properties and pay for them over time. Each payment you make represents a combination of interest and principal repayment. The amount of interest youll pay depends on your mortgage rate. Regardless, the majority of your mortgage payment pays a larger proportion of interest in the earlier stages of your loan, and the proportion of interest to principal changes over the life of the mortgage.
Your mortgage loan is amortized. which means it is stretched out over a predetermined length of time through regular mortgage payments. Once that period is over—say, after a 30-year amortization period—your mortgage is completely paid off and the house is yours.
When you take out a mortgage loan to purchase a home, your monthly payments consist of both principal and interest But you may be surprised to learn that in the early years of your loan, most of your payment goes toward interest rather than paying down the principal balance This changes over time, as more money is applied to principal reduction. But when exactly does this shift occur?
How Mortgage Amortization Works
Mortgages are amortized, meaning the loan balance is paid off over a set period through regular monthly payments. With a fixed-rate loan the monthly payment stays the same but the breakdown between principal and interest changes. In the beginning, interest makes up the bulk of the payment. But as the principal declines over time, less interest is owed so more money goes toward principal.
For example, let’s look at a $200,000 30-year fixed-rate mortgage with a 4% interest rate. The monthly payment would be around $955. In the first month, $666 goes to interest and $289 toward principal reduction. By the final payment, only $8 goes to interest while $947 is principal.
This demonstrates how the composition of the monthly payment shifts dramatically from primarily interest to mostly principal by the end of the term.
When is the Tipping Point?
The point where more money goes to paying down principal than interest is known as the “tipping point.” When this occurs depends on two key factors:
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Interest rate – The higher the rate, the longer it takes to reach the tipping point.
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Loan term – Shorter terms like 15 years reach the tipping point faster than longer 30 year loans.
To demonstrate this, here are some examples for a $200,000 fixed-rate mortgage:
- 4% interest, 30-year term – Tipping point occurs at month 154, or about 13 years.
- 3% interest, 30-year term – Tipping point at month 84, or 7 years.
- 5% interest, 30-year term – Tipping point at month 195, or over 16 years.
As you can see, the lower the interest rate, the faster homeowners reach the tipping point where principal payments surpass interest.
Strategies to Reach the Tipping Point Sooner
For most borrowers, it will take well over a decade before principal reduction outpaces interest costs. But you may want to accelerate this timeline. Here are two options:
Prepaying principal – Making extra lump sum payments or adding to your monthly amount will pay down principal faster. This reduces the balance owed, cutting the interest as well. Just be sure your lender doesn’t charge prepayment penalties.
Refinancing – Getting a new loan at a lower rate and/or shorter term can substantially reduce interest costs. You’ll reach the tipping point sooner. Shop around to find the best terms.
The Takeaway
Don’t be discouraged that your early mortgage payments seem to vanish into interest. This is perfectly normal due to the amortization process. The tipping point will come eventually, though it may take over 10 years. If you want to get there faster, prepaying principal or refinancing can help advance the timeline. Just be sure it makes financial sense for your situation first.
How Does Mortgage Interest Work?
Mortgage interest is the interest you pay on your home loan. It is based on the interest rate agreed to at the time you sign your contract. The interest compounds, which means the balance of your loan is based on the principal plus any accumulated interest. Rates can be fixed, which remain steady during the length of your mortgage, or variable, which are adjusted at various periods based on market rate fluctuations.
Your mortgage payment primarily goes toward interest in the initial stage, with a small amount of principal included. As the months and years go by, the principal portion of the payment steadily increases while the interest portion drops. Thats because the interest is based on the outstanding balance of the mortgage at any given time, and the balance decreases as more principal is repaid. The smaller the mortgage principal, the less interest youll be paying.
Depending on the terms of your loan, you may expect to pay as much as 50% of the mortgage in interest. The point at which you begin paying more principal than interest is known as the tipping point. This period of your loan depends on your interest rate and your loan term. Someone with a 30-year loan at a fixed rate of 4% will hit their tipping point more than 12 years into their loan. Having a lower rate will get them to this point faster.
This process is known as amortization. When you take out a mortgage, your lender can provide you with an amortization schedule, showing the breakdown of interest and principal for every monthly payment, from the first to the last.
Your monthly payments remain the same for the life of the loan with a traditional, fixed-rate mortgage. According to Consumer Finance, most types of home mortgages have terms of 15, 20, or 30 years.
Paying Down More Principal
As noted above, the time when you start paying more in principal is called the tipping point. The interest portion starts to drop with every subsequent payment. It can take years for you to get to that point.
Since the amount of interest you pay depends on the principal balance, you can reduce the total interest on your loan by making larger principal payments as you pay down the loan. You can do this by making a single lump-sum payment, which is normally called a prepayment, or by putting some additional money on top of your regular mortgage payment. Its very important you make sure there are no prepayment penalties built into your mortgage, as there may be a cost to making this prepayment.
Lets say your payment is $500 per month. your payments are $6,000 for the year. Adding an additional $100 for half the year means youre paying $6,600. That additional $600 ends up going to the principal balance.
While this may sound really good, the question remains: Should you pay down your mortgage with extra payments? That depends on your financial situation. It only really makes sense if you can truly afford it and if your income is enough to support an emergency fund and retirement account contributions among other things. After all, the money you use to pay down your mortgage is money that can be used elsewhere. And youll want to make sure your lender doesnt charge you any prepayment penalties or fees.
How Do Principal Payments Work On A Home Mortgage?
FAQ
What day of the month is best to pay extra principal on a mortgage?
Rather than delaying credit until the next month, the optimal day within the month to make an extra payment is the last day on which the lender will credit you for the current month.
How do I pay off a 30-year mortgage in 10 years?
To pay off a 30-year mortgage in 10 years, you’ll need to make extra payments or increase your monthly payments. Making biweekly mortgage payments can also help you repay your loan faster (but probably not that quickly).
At what point do you stop paying interest on a mortgage?
The point at which you begin paying more principal than interest is known as the tipping point. This period of your loan depends on your interest rate and your loan term. Someone with a 30-year loan at a fixed rate of 4% will hit their tipping point more than 12 years into their loan.
Is it normal to pay more interest than principal?