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Understand how interest rates work on “fixed” mortgages

Understand how interest rates work on “fixed” mortgages

Understand how interest rates work on “fixed” mortgages

If you have just started paying off your mortgage, then you might have noticed (maybe with some concern) that the amount you owe on your loan does not decrease as much as what you're paying. This can be confusing and discouraging, but don’t worry; you're not getting ripped off. You need to understand a little better how mortgage interests work.

You’ll always pay the same.

The first thing you need to know is that your P&I (Principal and Interest) will not change with a fixed mortgage. This is important because sometimes people might get confused and believe that as they start paying off their interests, their P&I, the monthly payment you make, gets lower. What actually happens is that there's a shift in the amount you pay towards interests and the amount you pay towards your principal.

Once that´s clear, we can now get into understanding your P&I.

To make things easier we will imagine a wonderful world in which you can buy a house for 15000$.

How is P&I calculated?

So after a long, complex search, you have finally found your dream house, and it can be yours for 15000$. You already have 50$ saved for your down payment, but you need to get a loan for the other 10000$; in this case, that loan is called a mortgage.

You decide to go with a 30 year, 5% fixed mortgage, which basically means you´ll pay 5% interest over the amount you owe each year, the rate will not change until your loan is fully paid. In this particular scenario, you would have a P&I (or monthly mortgage payments) of 53,68$. Doesn't that sound wonderful?

You make that first 53,68$ payment, and you think: “well, now I don't owe 10000$, I only owe 9946,32$,” but nope, actually, since you just took out the loan, your first payments are going to be mostly interest, so you will still owe 9988$.

How much of your payment is interest?

To understand how much of your payment is going into interest payments and how much into your principal payments, what you need to do is take the amount due (how much you still owe from the loan) then multiply it by the interest rate (5% so 0,05) and then divide it by the number of months in a year (12).

So: 10000$ x 0,05 / 12 = 41,66$ that's how much of your 53,68$ payments is going towards interest payments.

It seems like quite a hit at first, but the good news is that as years go by and your amount due gets lower, so make your interest payments. Let´s do the same exercise for your second payment:

Now the amount due is 9988$ x 0,05 interest rate / 12 months = 41,61$.

Each month, you´ll pay the same amount, but it´ll be less interest. By year 15, you'll start paying more towards your principal until one day, finally, your mortgage will be completely paid off.