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How is interest calculated on a mortgage?
The amount of interest you pay doesn't have to be set in stone.
From the interest rate your lender sets to the loan term you sign up for, there are several factors that affect how much interest you pay — and you can save thousands by taking advantage of those terms.
What factors affect the amount of interest you pay?
The following factors will affect the amount of your interest payments:
- The mortgage interest rate. This is the rate at which the bank charges you interest on the loan. Even a small difference in the interest rate can add up to thousands over the life of the loan.
- The federal funds rate. The interest rate on your loan is loosely tied to the federal funds rate set by the Federal Reserve, which dictates the rate at which banks lend money to each other overnight. If you have a variable interest rate, paying attention to the federal funds rate can help you predict what your interest rate will do.
- The amount you borrow. The more you borrow from your bank, the more interest you’ll need to repay. For example, 5% of $1 million will always be a larger amount than 5% of $500,000.
- The outstanding loan amount. As you gradually pay off the money you borrow, you will be paying interest on a smaller loan amount and your interest payments will slowly reduce.
- The loan term. The time you take to pay off your loan will affect the amount of interest you pay — paying your loan off over a shorter period of time will minimize your interest.
How is mortgage interest calculated?
Interest on your mortgage is generally calculated monthly. Your bank will take the outstanding loan amount at the end of each month and multiply it by the interest rate that applies to your loan, then divide that amount by 12.
Assuming you have an outstanding loan amount of $500,000 and an interest rate of 5% APR, your interest payment for one month would be calculated using the following formula:
($500,000 x 0.05) ÷ 12 = $2083.33
Principal and interest vs. interest-only
There’s another factor that can affect your monthly mortgage payment: whether you’re making principal and interest or interest-only payments. Principal and interest payments are the most common way to pay off a home loan, and they basically mean that one portion of your monthly payment goes towards paying off the amount you borrow and another portion goes to paying off the interest you owe.
However, some loans are designed to allow you to make interest-only payments for a certain period, for example if you’re building a new home or if you’re a property investor with an investment mortgage. This allows you to reduce your monthly payment amount.
Susie’s mortgage payments
Susie is borrowing $700,000 to buy a house and she wants to save as much money on interest as she possibly can. She decides to calculate just how much difference a 0.25% APR difference in interest rates could make to the total cost of a loan.
If she can find a loan with an interest rate of 4% APR on a 30-year loan term, her monthly principal and interest payments will be $3,341.91. The total interest she will end up paying over the life of the loan is $503,086.54.
But if Susie finds a loan with a marginally lower interest rate of 3.75% APR, her monthly payments will be $3,241.81 and the total interest over the life of the loan will be $467,051.29 — that’s a total interest saving of $36,035.25.
How to save interest on your mortgage
Now that you know a bit more about how interest is calculated let’s look at the ways you can actually pay less of it.
- Get the best rate. Shopping around for a better interest rate can save you thousands of dollars. If you already own a home, you may want to consider refinancing with your current lender or switching to a new lender.
- Make frequent payments. Because there are a little over four weeks in a month, if you make biweekly instead of monthly mortgage repayments, you’ll end up making two extra payments a year.
- Make extra payments. The quicker you pay down your loan amount, the less interest you’ll need to pay on your smaller outstanding loan amount. If you have a variable interest rate, you can save even more by making extra payments when interest rates are low.
- Choose a shorter loan term. The longer you take to pay off your loan, the more interest you’ll end up paying. Remember, banks calculate interest on your loan amount daily, so choosing a 25-year loan term instead of 30 years can make a big difference.
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Interest makes up for a substantial portion of your monthly mortgage payments, but choosing the most competitive home loan and making extra payments can help you cut tens of thousands off the cost of your home.
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