How a Mortgage Works

The story: The first statement

Marcus and Ana read their first mortgage statement and see that most of the payment went to interest.

1. Narrator: Marcus and Ana just bought a home with a $300,000, 30-year mortgage at an example 6% rate. The first statement arrives.
2. Ana: We paid about $1,800, but the loan only went down by about $300?
3. Narrator: Early on, most of each payment is interest. As the balance shrinks, more of each payment goes to principal.
4. Narrator: Many lenders also collect money for property taxes and insurance in an escrow account, and pay those bills for you.
5. Marcus: What if we add a little extra each month?
6. Narrator: Extra goes straight to principal. In this example, $200 more a month saves about $91,000 of interest.

What you’ll learn

1. Interest first, principal later

   Each payment covers the month’s interest first, and the rest pays down principal, the amount you borrowed. Early on the balance is big, so most of the payment is interest. This payment schedule is called amortization.

   Example: on a $300,000 loan at 6%, the first payment of about $1,799 includes $1,500 of interest and only about $299 of principal.

2. Escrow

   Many lenders add property taxes and homeowners insurance to your monthly payment, hold the money in escrow, then pay those bills for you. If taxes or insurance go up, your payment goes up too, even with a fixed interest rate.

3. Mortgage insurance

   With a small down payment, you may pay mortgage insurance. On conventional loans it’s called PMI, and it can be removed once you have enough equity. FHA mortgage insurance often lasts the life of the loan, so removing it usually means refinancing.

4. 15 years or 30 years, and extra payments

   A 15-year loan has bigger payments but usually a lower rate and far less total interest. A 30-year loan has smaller payments and more breathing room. On either one, extra payments toward principal cut the interest you’ll pay over time.

Key words

amortization

the schedule that splits each payment between interest and principal

principal

the amount you borrowed and still owe

escrow

money a lender holds to pay your property taxes and insurance

loan term

how many years you have to pay the loan back

Common questions

Is it better to pay extra or invest?

It depends on your rate, your other debts and your emergency fund. A lesson comparing paying off a mortgage early with investing is coming.

Why did my payment go up with a fixed rate?

Usually because property taxes or homeowners insurance went up, so the escrow part of your payment grew.

Remember this

Interest first, principal later. Extra payments flip that.

Try it: See how your loan splits

1. Find your mortgage balance, rate and payment, or use the example from this lesson.
2. Run the Loan Payoff Calculator.
3. Try an extra monthly payment and see the interest saved.

No account needed: the Loan Payoff Calculator is free and public, or try it on the sample household in the demo.

Live facts

Numbers that change over time, with when they were last checked and where they come from.

• How paying down a mortgage works

  Source: ConsumerFinance.gov(opens in a new tab)

• When you can remove PMI

  Source: ConsumerFinance.gov(opens in a new tab)

• What an escrow account is

  Source: ConsumerFinance.gov(opens in a new tab)

• FHA, VA and USDA loans and their fees

  Source: HUD.gov(opens in a new tab)