Understanding How to Calculate Mortgage Principal, Interest, and Payments
June 8, 2023
Understanding how to calculate interest payments is an important part of financial education. Knowing how to calculate the amount of interest owed on a loan is essential for budgeting and planning, as well as improving your credit score. In this blog post, we will discuss why it’s important to understand how to calculate interest payments, how to calculate those payments, and the benefits of knowing how to do so accurately.
Let’s go over some key terms before we get started here and we’ll define them further along the way:
- APR - Annual Percentage Rate
- PITI - Principal, Interest, Taxes and Insurance
- P&I - Protection and Indemnity Insurance
How to Get a Home Loan
First, let’s talk about exactly how people start the home buying process. Assuming a borrower has qualifying credit and income, along with a down payment (or down payment assistance), there are a couple of steps they need to take even before talking to a real estate agent.
Once a borrower knows how much house they can afford, they can research interest rates and choose a lender. Working with a lender first lets the borrower know what they may qualify for, and (once prequalified), a real estate agent knows they are serious about buying a house.
Borrowers will need to provide a lender with information such as their employment history, income and debts. The lender will also need to pull a copy of their credit report. After the lender reviews the borrower’s information they submitted they will either be prequalified or denied by the lender. When prequalified, the lender will give a borrower a prequalification letter which outlines all the details of the loan including the estimated interest rate and term of the loan, and sometimes even the monthly payment amount.
Borrows need to make sure they read over this carefully before signing!
Defining Mortgage Principal Versus Interest
When dealing with mortgages, it's important to understand the different factors that make up your overall payments. Principal and interest are two key pieces of this puzzle;
Definition of Mortgage Principal
Principal is the amount borrowed for a loan, while interest refers to the fee charged for borrowing money. Principal payments go towards reducing the balance on a loan and typically comprise a large portion of each monthly payment.
Definition of Mortgage Interest
Interest payments are calculated as a percentage of the principal and can vary depending on the type of mortgage taken out. Fixed-rate mortgages typically have an interest rate that doesn't change over time, while adjustable-rate mortgages often start with a lower interest rate but may increase over time. Interest is also determined by the loan's APR and the amount of time it takes to pay off the loan.
Knowing how principal and interest are calculated in relation to a mortgage can be crucial for sound financial planning. When considering a loan, it’s important to understand not only what the total monthly mortgage costs, but what interest and fees are being paid. This allows borrowers to make more informed decisions when budgeting or considering refinancing options.
How to Calculate First Month's Reduction in Principal
Once a borrower has signed and closed on the loan, their first mortgage payment will be due as soon as the start of the following month.
To calculate this, simply divide the annual interest rate by 12 to get your monthly rate (for easier math we’ll calculate with a 6% interest rate),
- Convert the percentage rate to decimal format
6% ÷ 100 = 0.06
- Divide that by 12 to get the monthly rate.
0.06 ÷ 12 = 0.005
- Next, multiply that number by the total principal loan amount (we’ll say the house was sold at $150K)
0.005 x $150,000 = $750
- This tells us that $750 of the first month’s mortgage payment will be interest.
- To understand how much of the payment is going to principal, simply subtract the interest from the total payment balance stated on the loan paperwork (we’ll say the total mortgage payment was calculated at $925)
$925 - $750 = $175
This means that $175 of the first payment is going to principal, taxes, P&I Insurance, and Property Taxes if applicable giving use the principal payment or remainder of the PITI if insurance and taxes have been figured in.
We could string that formula together to look like this
(purchase price x (APR ÷ 12 months)) - total payment = PITI
($150,000 x (0.06 ÷ 12)) - $925 = $175
Of course, this is just an estimate - actual payments may differ based on factors such as escrowed funds for taxes and insurance.
Now they can go out and shop for that perfect home knowing how to calculate one important factor in homeownership - their first mortgage payment! Since most people finance their home purchase with some type of mortgage loan arrangement where they make periodic payments toward both principal reduction as well as paying back accrued interest charges levied by their financial institution – it stands to reason that understanding how these types of calculations work is extremely important for anyone considering ownership in residential property.
If nothing else – getting familiarity with some simple math concepts related to mortgages can help put any potential buyer’s mind more at ease during what is typically one of biggest financial undertakings they will ever undertake in their lifetime.
But beyond just giving someone “peace of mind” when it comes time crunching numbers associated with their future home purchase, learning about things like amortization schedules can actually save buyers hundreds to tens of thousands of dollars over time.
You probably already know that making regular contributions towards repaying both principal AND accumulated interest on any outstanding balance owed on some such debt instruments like auto loans or student loans is pretty much standard operating procedure for savvy money management but figuring out HOW those periodic payments are calculated might still be somewhat confusing, so let's take a look at one typical scenario related To repayment Of borrowed funds secured By real estate Which Usually takes The form Of A so-called "first mortgage" arrangement And see If We can sort things out a bit.
When someone borrows money from any kind of lender for just about any reason really whether it's to buy a car or pay for college or maybe even refinance an existing debt obligation like a credit card balance that carries a high interest rate. You will probably have some sort of regularly scheduled repayments set up wherein you will make contributions credited towards both reduction in the outstanding principal balance owed as agreed upon.
How to Calculate First Mortgage Payment
Knowing how to calculate mortgage payments by hand is easier than people think and a good tool to have in your back pocket. This calculation entails dividing the initial loan amount by the number of months it will take to repay said loan. To do so accurately, you'll also need to consider how much interest will be paid each month; principal payment depends not only on how much was originally borrowed, but how much will go toward principal and how much will go towards interest. With that knowledge in hand, let’s look at the formula:
- The formula can be notated as M = P [ i(1 + i)^n ] / [ (1 + i)^n – 1] where:
- M = monthly payment,
- P = total loan amount,
- I = interest rate (as a monthly percentage)
- N = the term of the loan in months.
- Let’s use the same numbers as before (on a 30 year fixed) to make sense of that and find M (monthly payment). First Let’s notate that formula in with our numbers
M = $150,000 x (0.005 Monthly Interest Rate x (1 + 0.005)^(30 years x 12 months))/((1 + 0.005 Monthly Interest Rate)^(30 years x 12 months) - 1)
- now clean it up
M = 150000 x (0.005 x (1 + 0.005)^360) / ((1 + 0.005)^360 - 1)
- To solve let’s break this down by the order of operations (Parentheses, Exponents, Multiplication, and Division, Addition and Subtraction)
(1 + 0.005)^360) = 1.005^360 = 6.0226
((1 + 0.005)^360 - 1) = 5.0226
(0.005 x 6.0226) / 5.0226) = 0.0301 / 5.0226 = 0.00599547566227
150000 x 0.00599547566227 = 899.321349340463532
Benefits Of Knowing How To Calculate Your Interest Payment Accurately
Knowing how to calculate interest rates on loans accurately is essential for increasing financial security and wellbeing. It can also benefit:
- Increase Financial Literacy & Awareness - By understanding how much money you will owe each month in terms of both principal and interest payments on any given loan or debt instrument can help increase your financial literacy and awareness regarding investments and debt management strategies
- Create More Accurate Budgeting Strategies & Planning - Properly calculating what you owe each month helps ensure that all bills are paid on time while leaving enough money left over for savings and other discretionary spending
- Improve Credit Score & History with Timely Payments - Making timely payments helps boost credit scores because lenders view borrowers who pay their loans off early as lower risks than those who don't or who make late or incomplete payments.
Working with mortgage principal, interest and payments is something you will do a lot as an agent or broker. You can help homeowners understand their financial objectives better and improve their home budgeting decisions. By managing the total principal and interest of a loan, individuals can develop an action plan that fits into their overall financial objectives. Having an understanding of how to calculate the first month's reduction in principal and the monthly mortgage payment can provide a combination of tax benefits and maintainable cash-flow options for the homeowner.
Want to learn more? Fortunately, ExamSmart offers educational programs in real estate that serves as invaluable resources by providing you with detailed update-to-date information on all 50 states. Do not wait around any longer – Use Examsmart now to gain advantage of having a strong background in fundamental concepts so you are able to easily pass your real estate exam!
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