What's in this article?
If you’ve been looking into purchasing a home, you have probably wondered about the terms principal vs. interest and how they might affect your mortgage payments.
Understanding what your mortgage may include and the terminology used while buying a new home may seem intimidating at first, but it will become a little easier after familiarizing yourself with a few key terms.
Your principal and interest will make up the majority of your mortgage payment. To understand what they are and what it means for you, continue reading.
Financial Breakdown of a Mortgage
There are two main components to a monthly mortgage payment when you borrow money to purchase a home. You have your principal, which is the money that you borrow, and your interest, which is what you pay your lender for allowing you to borrow from them.
While the largest part of your loan will come from the principal and interest, there may also be other fees added to your monthly payment as well. This could include taxes, homeowners insurance, and mortgage insurance.
To determine which type of mortgage is best for you and how much house you can afford, it is essential to better understand principal vs. interest. Continue reading to learn what the key differences are.
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Principal: Earn Equity as You Pay Toward the Value of Your Home
Your principal is the sum that you borrow when you first take out your home loan. Your mortgage lender covers your loan’s cost, and you make payments on this for 15 or 30 years, depending on the type of loan you have chosen. There are other loan term options as well, but these two are the most common.
For example, if you find a house that will cost you $250,000 and put 20% down ($50,000), you would need to borrow the remaining $200,000 from a lender. The $200,000 is your principal.
So you can see that the principal relates directly to the price or financial value of the home you’re purchasing. As you pay down the principal, you gain equity in your home, which is the amount of your home that you actually own.
When paying your mortgage over time, the amount you pay toward principal increases, while the amount you pay toward interest decreases. The interest is front-loaded. Once you are far enough along in the amortization of your loan, the principal will account for a larger portion of your monthly payment.
If you’re interested in seeing how much of your potential monthly mortgage payment will go toward interest and how much will go toward the principal, you could use a mortgage amortization calculator.
Interest: Money the Lender Earns as You Pay Back Your Loan
Your interest makes up another important part of your monthly mortgage payment. It is what you pay to your lender in exchange for granting you a loan.
With principal, once a price is agreed upon for the home, the only way your principal can change before your loan is finalized is if you make a larger down payment. This differs for the interest rate, where there are many other factors that can impact it while your mortgage is being processed.
Determining factors for your interest rate can include the following:
- Your credit score
- Market rates
- Home location
- Home price
- Loan type
- Interest rate type
- Loan term
As for loan terms, if you choose a shorter loan term, your interest rate will be lower. However, while your interest rate will be lower, your monthly payment may be higher. If you can afford a higher monthly payment, choosing a short-term loan with a lower interest rate could save you money in the long run.
Interest rates also differ with the various loan types, such as conventional, FHA or VA. For example, FHA loans tend to have lower interest rates than conventional loans, because they require you to pay mortgage insurance, which lowers the risk to the lender. Whereas with a conventional loan, the interest rate can be lowered by making a larger down payment if you can afford to.
Can My Principal or Interest change?
Your principal and interest will remain the same as you pay off your loan if you have a fixed-rate mortgage. If you choose an Adjustable-Rate Mortgage, your interest rate will change over time.
Adjustable-Rate Mortgage (ARM)
An adjustable-rate mortgage is a type of mortgage that involves getting an interest rate that changes when the market rates change.
In the beginning, your interest rate will be lower, meaning your monthly payments will also be lower. Over time, your interest rate will fluctuate, depending on the market. When the market rates go up, your interest rate will go up. When the market rates go down, your interest rate may also drop.
Due to the changes in interest rate, your monthly payments will continue to change as well, until your mortgage is paid off.
Do you need help understanding mortgage terms?
With this guide, you probably have a better idea of how monthly mortgage payments are made up of mainly principal and interest. With this information, you can get an idea of your monthly mortgage payments and how much house you can afford. This is also the foundation that can help you understand what type of loan you would prefer, such as a short term or long term, conventional or FHA.
Understanding principal vs. interest, like other mortgage terms, can be challenging. If you have any questions, feel free to reach out to one of our dedicated loan officers. We can answer your questions, discuss your needs, and provide you with expertise and recommendations for your mortgage so that you can afford the home you want.
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