Principal Vs. Interest Component of a Payment
Mortgages come with their own set of terminology and acronyms, like amortization, balloons, PITI and ARMs. Once you select a mortgage, however, there are two things to worry about -- how much of your payments your lender applies to the principal and how much goes toward interest.
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Mortgage Basics
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Once you take out a mortgage to purchase a piece of real estate, your lender uses a method called amortization to determine your payments. To amortize a mortgage, you need four critical pieces of information: the original loan amount, the interest rate, the length of the loan and the number of payments annually. Amortization basics remain the same whether your mortgage has a fixed or adjustable interest rate, or whether the loan has a repayment method that is a variation of a traditional mortgage.
Principal
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Mortgage principal is the amount of the original loan minus any money you have repaid. When you begin your mortgage repayment schedule, the lender applies only a small fraction of your payments toward the principal. After each payment, however, the lender recalculates the loan based on the new lower balance. In this manner, the amount applied toward principal grows with each payment while the amount of interest declines, although the total payment does not change.
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Interest
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Interest is what the lender charges in return for loaning you money, and is generally a percentage of what you borrow. Although calculating a mortgage payment is complicated, determining the amount of interest due at each payment is a relatively easy calculation. Simply take the loan's interest rate and divide it by the number of payments made each year -- 12 for a loan with monthly payments, or 26 for a loan with bi-weekly payments. Multiply the principal balance by that number to determine the amount of interest due. If your principal is $100,000 and you make monthly payments at 6.0 percent interest, the calculation (6.0% divided by 12, times $100,000) results in an interest payment due of $500. In most instances, the interest you pay on the mortgage for your primary residence is tax-deductible.
Total Payments
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Interest and principal are not always the only components in your mortgage payment. Many lenders collect four streams of money, referred to as "PITI," in the payments: principal, interest, taxes and insurance. Lenders collect real estate taxes and homeowner's insurance to protect their investments, too. Real estate taxes vary depending on the home's value and the millage rate of the town where the property is located. If you fall behind in your real estate taxes, your city has the right to foreclose on the home and sell it to cover the taxes in arrears. Likewise, if you fail to insure your property, and a fire or other disaster strikes, the lender no longer has the home as collateral to secure the loan.
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