When you take out a mortgage, one of the challenges that people often face is understanding the long list of complicated terms and lingo. Two common terms often used in the world of banking, including mortgages, are principal and interest. First-time home buyers, in particular, may not fully understand how their mortgage payments are determined. Simply put, it all comes down to principal and interest.

Below, we explain the difference between the two and apply these concepts to help you manage your personal finances.

What Is Your Principal Payment?

The principal is the amount of money you borrow when you originally take out your home loan. To determine your mortgage principal, just take the sales price of your home and subtract the amount of your down payment.

For example, if you buy a home for $300,000 with a 20% down payment. In this instance, you would have put down $60,000 toward your loan. Your mortgage lender would then cover the cost of the remaining amount on the loan, which is $240,000, which would be your principal balance. Your principal is the most important factor in deciding how much home you can afford. The principal you borrow accumulates interest as soon as you take it out.

Each month, part of your mortgage payment will go toward lowering your principal balance. It’s important to be aware that the principal starts accumulating interest as soon as you close on your loan.

What Is Your Interest Payment?

The second major part of your monthly mortgage payment is interest. Interest is money you pay to your mortgage lender in exchange for giving you a loan. Lenders charge interest as a way to profit from lending money. That means you have to pay back what you originally borrowed plus some extra. However, the amount of interest lenders charge differs from one lender to the next, as well as between different types of loans.

The amount of interest you pay over the life of your loan will depend on your interest rate. When you apply for a mortgage, your lender will evaluate your eligibility and offer you an interest rate based on factors that include your:

  • Credit score
  • Income
  • Down payment
  • Debt-to-income ratio
  • Housing market

Interest Rate vs. APR

It is also worth mentioning that the interest rate on your loan is not technically the same as its annual percentage rate (APR). Though these terms are sometimes used interchangeably, they are two different things, and both are important to understand.

  • Interest rate on your loan is the cost you pay to borrow the funds from the lender.
  • APR reflects the interest rate plus other expenses, like mortgage points, fees and any other charges associated with borrowing the money.

The APR is a broader measure of what it will cost you to pay back the loan, so it is typically higher than the pure interest rate. If you are comparing loan offers from different lenders, be sure to examine the APRs and interest rates separately. Do not compare the interest rate from one lender with the APR of another, for example.

How are Principal and Interest Calculated?

Lenders multiply your outstanding balance by your annual interest rate, but divide by 12 because you’re making monthly payments. So if you owe $300,000 on your mortgage and your rate is 4%, you will initially owe $1,000 in interest per month ($300,000 x 0.04 ÷ 12). The rest of your mortgage payment is applied to your principal.

Is It Better to Pay Off Principal or Interest First?

As a general rule, it is better to pay off your principal first. Although your amortization schedule will outline a plan for paying off your loan, you may be able to pay it off faster and avoid some interest by putting extra money toward your principal. The faster you pay off your loan principal, the less you will pay in interest.

Using a loan principal and interest calculator is a good strategy for helping you make a plan for paying down your principal balance faster. By understanding all of the terms and conditions involved with personal loans, you can get a better idea of the money you’ll ultimately owe.

When you make monthly payments to the lender, everything you pay above the interest payment amount goes toward paying off the principal. The more you deposit into the credit account, the faster you reduce your principal balance, and the less you usually have to pay in interest.

Other Components of Your Monthly Mortgage Payment

While your principal and interest make up most of your monthly mortgage payment, you may also pay money into an escrow account as part of your mortgage payment each month. Your lender will then take the money in your escrow account to pay important mortgage-related expenses on your behalf.

These expenses most often are:

  • Property Taxes

All homeowners must pay a property tax, which goes to their local government to fund public services such public schools, roads, recreation fire departments and libraries. Taxes are one of the most overlooked parts of owning a home, and they can also be one of the most expensive. Property taxes go to your local government and fund things like.

The amount you pay in taxes depends on the value of your home and the local amenities your community offers. Part of the reason you get an appraisal when you buy a home is so your local government can correctly calculate your taxes. Taxes can vary from year to year, and your county might require you to get a new appraisal every few years.

  • Homeowner’s Insurance

You are not legally required to have homeowner’s insurance to own a home. However, most mortgage lenders will not give you a loan without insurance. Homeowner’s insurance protects you against damage from fires, break-ins and lightning storms, just to name a few examples. You may need an additional policy to protect yourself from damage caused by flooding and earthquakes.

Mortgage insurance is calculated as a percentage of your home loan. The lower your credit score and the smaller your down payment, the higher the lender’s risk, and the more expensive your insurance premiums will be. But as your principal balance falls, your mortgage insurance costs will go down, too.

If the amount you owe in homeowners insurance, property taxes or both changes over the life of your loan, your lender will reassess the amount you pay into escrow each month and raise or lower your monthly payment accordingly to ensure these costs remain covered.

Find the Right Agent

Buying your house should be a fun and fulfilling experience. If you have done your research and evaluated what you can afford and what you truly need, finding a new home can be exciting. Learning more about the purchase process eliminates the fear of the unknown and lets you search for a home with peace of mind.

Windermere’s community of real estate professionals is our greatest asset. We have experts in all areas of real estate, from your typical starter home to condos, luxury properties, and new construction. While residential real estate is the mainstay of our business, Windermere also has offices and associates who specialize in property management, commercial real estate, and relocation services. To further facilitate the home buying process, Windermere has affiliated partners in certain regions to provide mortgage, title, and escrow services.

Call us today with any questions or concerns. Our professional Real Estate Agents will help you through this exciting process. (951) 369-8002