It Is All About The Interest
To help calculate a loan’s monthly payments based on different interest rates, lenders have developed amortization tables. These tables easily calculate how much money of each payment is interest, and how much goes towards the principal balance.
For example, let's calculate the principal and interest for the first monthly payment of a 30-year, $100,000 mortgage loan at 7.5 percent interest. According to the amortization tables, the monthly payment on this loan is fixed at $699.21.
First, we calculate the annual interest by multiplying $100,000 x .075 (7.5 %). This equals $7,500, which we then divide by 12 (for the number of months in a year), which equals $625.
If you subtract $625 from the monthly payment of $699.21, we see that $625 from the first payment interests while $74.21 goes towards the principal. Next, if we subtract $74.21 (the first principal payment) from the $100,000 loan, we come up with a new unpaid principal balance of $99,925.79. To determine the next month's principal and interest payments, we just repeat the steps already mentioned.
We now multiply the new principal balance ($99,925.79) times the interest rate (7.5%) to get an annual interest payment of $7,494.43. Divided by 12, this equals $624.54. So, during the second month's payment:
$624.54 is interested while $74.67 goes towards the principal.
As you can see from the above example, while you pay a lot of interest up front, you're also slowly paying down the overall debt — known as building equity. Thus, even if you sell a house before the loan is paid in full, you only have to pay off the unpaid principal balance — the difference between the sales price and the unpaid principle is your equity.
To build equity faster — as well as save money on interest payments — some homeowners choose loans with faster repayment schedules (such as a 15-year loan).
Time Versus Savings
To help illustrate how this works, consider our previous example of a $100,000 loan at 7.5 percent interest. The monthly payment is around $700, which over 30 years adds up to $252,000. In other words, over the life of the loan, you would pay $152,000 just in interest.
With the proactive repayment schedule of a 15-year loan, however, the monthly payment jumps to $927 for a total of $166,860 over the lifespan of the loan. Obviously, monthly payments are now more than those for a 30-year mortgage, but you would save more than $85,000 in interest overall.
Shorter-term loans are not the right answer for everyone, so ask your lender or real estate agent about the best loan for your situation.
Understanding how much you can afford is probably the most important rule of home buying. Your budget can affect everything — from the neighborhoods you look for, to the size of the house, and even the type of financing you choose.
Just remember that lenders will look beyond your income alone to determine the amount of your loan. Likewise, you may find there are some innovative financing options to help boost your purchasing power.