How Mortgage Principal and Interest Works
When you're looking at your home loan, it's important to understand what your mortgage payment is going towards each month and how your lender is calculating this amount.
So what is principal?
Principal is the amount borrowed or the amount still owed on a loan. For a $200,000 mortgage, the principal is $200,000. Loans are structured so that the amount of principal being paid increases with each mortgage payment. When you pay back your lender, you pay them more than $200,000. You also pay interest on the loan.
What is interest?
Interest is the cost of borrowing money, stated as a percentage, charged by a lender on the principal amount of your mortgage. There are a few reasons you pay interest:
1. The risk of principal loss by the lender, called credit risk.
2. Lender forgoing other investments that could have been made with the loaned amount, known as the opportunity cost.
The interest rate on your mortgage has a direct impact on the size of your mortgage payment. If you have a higher interest rate, your monthly mortgage payment will be higher.
While lenders will decide who gets approved for a loan and on what terms, interest rates are largely controlled on the secondary market, where mortgages are bought and sold.
Ja Yung, a mortgage banker, explains an important aspect of the relationship between principal and interest: For principal and interest payments, the interesting thing is that it's not an even split amount. So every single month when you, say, make a $500 payment, it's not that $100 goes into the interest and $400 towards the principal every single month.
"So you kind of think of it like a sloping mountain in a sense where in the beginning of the term, you pay the most interest and as time goes by, you pay less and less interest so that mountain starts sloping down and what happens then, because your payment is staying the same, that while the interest portion decreases, the principal payment or the monies that's going to actually pay down the loan will increase month over month.
We hope you've found this video and the many others on the My New Home YouTube channel helpful. Here are some other resources you might be interested in.
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