Why does so much of my mortgage payment go to interest?

by Mortgage Nerd on May 25, 2011 · 3 comments

TLDR: 30 year fixed = lots of interest and most of it at the beginning.

Buying a home can be such an exciting new venture. However, it is not uncommon for new homeowners to become quickly disenchanted with home ownership when they realize  how slowly they are paying off their 30 year mortgage.  It happened to me when I bought my first house.

After 1 year I noticed on my mortgage statement that my loan balance had only gone down exactly $1,438. Basically I paid $10,500 ($875/mo)  to own $1,438 more of my home. My first thought was that the bank was raking me over the coals. I think I may have even made a call to the lender to find out what the heck was going on. Ultimately I decided that I wanted a piece of that scam and I got into lending…J/K.

Fast forward 5 years and I have a whole new understanding of how the 30 year fixed rate mortgage works. I guess I should or I probably shouldn’t be a loan officer. I would like to share with you some of my thoughts and hopefully help you realize that the bank is not raking you over the coals with a 30 year fixed mortgage (They have other ways to do that).

Math Disclosure: The following paragraphs include math…May make for boring reading…Please bear with me.

When you make a mortgage payment on a 30 year loan (or any loan term for that matter) the bank is simply charging you the interest that is due on the principal amount owed. For example, on the first payment for a loan amount of $100,000 with an interest rate of 5%, the interest owed is calculated by multiplying the interest rate (5% or .05) by the loan amount ($100,000) and dividing it by 12 months. The interest owed for that month would be $416.67.

Now whether you have a 30 year, 40, 25, 20, 15, or 10 year mortgage loan, the amount of interest due on a balance of $100,000 at 5% will always be $416.67. The difference between those mortgage types (i.e. 10, 15, 30 year terms) is the amount that you are forced to pay to principal so that the loan is paid in full in the time allotted in the contract. Naturally on a 15 year mortgage you will see a lot more go to the principal with each payment.

Hypothetically if you pay that $416.67 along with a payment to principal of $1,000 than for your next payment you will only have to pay the interest due on $99,000 at 5%, or $412.50. Then if you wanted to bring your mortgage balance to $98,000 you would only have to pay $1,412.50. It would be interesting if mortgages worked that way. (see next paragraph….I mean “keep reading or suffer the consequences!”)

What if the interest was fixed but the payments were not? (loans don’t work this way so the following part is just for fun. I know I said “fun”…That is why I am The Mortgage Nerd)

Such a mortgage product could exist because the bank would still earn the interest that is due each month but I think there is a small amount of the population that would want to start with the higher payment. Just for kicks and giggles let’s look at the basic math behind a mortgage that might work that way.

Let’s use the 30 year mortgage of $100,000 at 5% again. If you were to pay off this mortgage over 360 months (30 years) with equal principal payments each month, you would have to pay $277.78 to the principal balance each month. Again, the first month you would pay 5% interest on the full $100,000, which would equal $416.67 [($100,000 x .05) / 12)]. Your first month payment would be $277.78 plus $416.67, or $694.45.  The second month you would owe less interest and your payment would go down to $693.95, and as you paid the principal down by $277.78 month after month, your monthly payments would decrease every month until the mortgage is paid in full, in 30 years. Your last payment would be $277.78.

How it really works

With a traditional 30 year fixed mortgage today the payments are fixed. What this means for you is a lower payment at first with much more of your payment going towards the interest. Instead of starting out at $694.45 and having your payments go down each month, you start with a payment of $536.82 and end with that same payment in 30 years.

It’s great that you have a low payment but it is kind of a bummer that you aren’t putting hardly anything to the principal balance at the start. In fact, it would take a whole 16 years before the amount of your payments applied to interest and principal are split 50/50. It’s not that the bank is trying to take advantage of you. They are simply collecting the amount of interest that is due, which comes down to simple math.

In fact, the current 30 year fixed fully amortizing mortgage was designed to make buying a home more affordable for you and to make budgeting easier. However, you don’t have to like it and there is a strategy for making those early mortgage statements more tolerable.

Best strategies for saving money on interest on the 30 year fixed mortgage

  • Get a 25, 20, 15, or 10 year fixed mortgage or…
  • Pay more than is due each month

Ok I admit I am being a little sarcastic, but nerds can be jerks sometimes. Just because you signed up for a 30 year mortgage doesn’t mean that you can’t pay if off sooner by paying a little extra to the principal each month(unless you have a pre-payment penalty and in that case your lender is a way bigger jerk than I am). I’m not going to do the math (done enough of that already) but if you can make 1 extra payment per year than you can pay off your 30 year mortgage around 7 years faster.

More evidence that the 30 year mortgage is not a “scam”

If bankers made more money by front-loading the interest than they would want everybody to do a 30 year mortgage and offer a lower interest rate than the 15 year or 10 year mortgage. This is not the case as they offer interest rates that are substantially lower on 15 and 10 year mortgages. They prefer the shorter term mortgages as it frees up their money more quickly and they aren’t subjected to the risk of rising interest rates. Also, borrowers that pay down their mortgages faster are less likely to default.

Hopefully your new found wisdom about the 30 year mortgage and how the interest is calculated gives you some peace of mind when your mortgage statements come in the mail. I know that many financial planners would have you not pay extra on your mortgage and invest your extra money with them. I, on the other hand feel that it can’t hurt to pay a little extra and pay down your mortgage faster. The stock market hasn’t been that great lately anyways.

{ 3 comments… read them below or add one }

Greg May 27, 2011 at 6:37 pm

Excellent piece!


Ste October 13, 2011 at 10:18 pm

Thanks for the article, however, how does this work when you change mortgage provider?
If you pay so much to the first mortgage provider and change to another, you pay £10,000 but only £1,400 off the mortgage to the first provider, who take £8,600 off you for that initial period, how does that interest paid factor into the new mortgage with the new provider?
I know this is obviously how it works, but it seems like the first provider is committing daylight robbery!


Lost in the numbers November 10, 2011 at 11:06 am

Hi Mortgage Nerd! I get a bit lost in the numbers at time, so I apologise if you’ve already answered this in your article above. My question is, how come my debit interest varies from month to month (can vary up to $200) when I am (1) making additional payments and (2) am reducing my principal on a monthly average of $3,800 a month?

A bit about my home loan…it is a variable rate but has not changed rates in the last 10 months and only recently there has been an announcement of a rate cut in the last week. My debit interest for this month was $1466.93 compared to the previous month of $1348.04. The only redraw I took from this month was $42.

I’m a bit lost that if I am reducing my principal, with little redraw and on a static rate, how my payments can fluctuate higher?

Help please!

Lost in the numbers


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