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How does mortgage interest work?

Answer

The mortgage interest rate is the price you pay for borrowing the money to buy your home. The interest rate is an annual rate but is calculated and applied as a monthly rate. The lower the interest rate, the less you will have to pay.

For a fixed rate mortgage, to find the monthly amount of your payment that is paid in interest, take your interest rate and divide by twelve. As an example:

  • Your mortgage interest rate is 3 percent. 3.0 divided by 12 = 0.25, the monthly rate is 0.25. If the mortgage is for $100,000, calculate $100,000 times .25 percent, which is $250.00. You will pay $250.00 of your monthly mortgage payment in interest for the first monthly payment.

    So, if your monthly payments were calculated to be $506.90, $250 will go for interest and the rest ($256.90) will be used to pay down the mortgage (principal). Each month, the interest payment will go down and more of the monthly mortgage payment will be used to pay on the principal. This happens because as the months go by, you are paying the principal down and the interest on the monthly amount of your mortgage is less.

    So, on a $100,000 dollar mortgage, on the first month you paid $256.90. So, $100,000 minus $256.90 = $99,743.10. For the second month, of the $506.90, your interest will be paid on $99,743.10. You will pay $249.35 in interest, and $257.55 towards the principal. This happens for every month of your mortgage.

You will wind up paying thousands in interest by the end of the mortgage. At the closing, the bank or mortgage company should give you an amortized payment schedule showing you how much you will pay in interest over the duration of the mortgage. This amount could be a shock to a first time homebuyer, but that's the way it is.

More Homeownership FAQs from Low Income Households

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