How a 30-Year Mortgage Works
The 30-year mortgage is the workhorse of the home finance industry. News references to "mortgage interest rates" invariably refer to 30-year fixed mortgage rates. In addition, Adjustable Rate Mortgages, balloon mortgages and various government-backed mortgages are all geared to 30-year mortgage amortization tables.
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Definition
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A 30-year mortgage is a long-term loan contract using your home as collateral. You pay the mortgage off, with interest, in 360 monthly payments --- a 30-year period. The lender --- typically a bank, credit union or mortgage company --- can take over ownership of the home through foreclosure if you fail to repay the loan on schedule.
Interest Rates
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The lender charges you an interest rate on the loan. On a 30-year fixed-rate loan, the most common mortgage, the interest never changes until the loan is paid off.
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Monthly Payments
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Not only does the interest remain the same, the monthly payments for a 30-year fixed-rate mortgage don't change either. However, the amount charged in interest and the amount that is applied against the principal --- the original loan amount --- change each month.
Amortization
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Recalculating the interest and principal every month is called amortization. In short, the quoted interest rate, say 6 percent, is compounded 12 times a year, resulting in a monthly rate of 0.5 percent. To calculate the interest you will be charged for a given payment, that monthly rate is multiplied by the remaining principal.
At the beginning of a loan, most of your payment is interest. Here's why: For the first payment, the monthly rate is multiplied by the entire amount of the loan. The second month, the monthly rate is multiplied by the remaining amount after some of the loan amount has been paid. Even if the loan amount is reduced by just $100, the interest paid in the second month will be a bit lower. Gradually, more of the payment is applied to retire the principal. It takes about 18 years for more than half of the payment to be applied as principal, but at the end of the loan, when the loan balance is small, you will pay almost no interest each month.
Figuring The Payment
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The simplest way to figure your payment is to use an online amortization application (See Resources), or use the PMT formula on a Microsoft Excel spreadsheet. But if you really want to know how the math works, see How To Figure Amortization Schedules by Hand in the Resources section below. It will take you through a complicated formula, but at the end, you'll come up with the same number as if you used a computer program, plus you'll really understand loan amortization.
Total Interest Paid
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On any interest rate greater than 5.3 percent, you'll pay more interest than principal over the life of a 30-year loan. For example, on a $100,000 loan at 6 percent, you'll be charged $115,838 in interest if it takes you the full 30 years to pay off the mortgage.
Paying Points
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One way to lower your interest rate is by "paying points." A point is 1 percent of the value of the loan; for a $100,000 loan, a point would be $1,000. In return for the point at the start of the loan, the lender will lower the interest rate on your mortgage. If you plan to stay in your house for a while, it might be worth paying the points. For example, paying a point on a $100,000 loan to lower your interest rate from 6.25 percent to 6 percent would result in a lower house payment of roughly $16 per month. It would take less than six years to gain back the $1,000 point, and you would pay nearly $6,000 less in interest over the 30-year life of the loan.
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