Preparing for mortgage means lots of documents organization and going back and forth with your underwriter. In the end, when you are told your monthly payment is xxx based on interest rate ###, you take it as a given answer and don’t think about how it is calculated. This is convenient, however you are missing valuable information if you leave it as “some number the bank told me”. Here, let’s see how your mortgage is calculated and what we can find out through this.

First we need to get a few things clear:

  1. We use monthly interest rate here. It equals your annual interest rate divided by 12 months.
  2. Your monthly payment is a fixed amount.
  3. In the end of the last month of your mortgage, you will own $0 to your bank

Great, now let’s take an example: Emma just bought a home and got a loan of $10, 000 with 3% interest rate for 1 year (12 months). How could she know what’s her monthly payment?

Here the monthly interest rate is 3% / 12 = 0.25%. Assume the monthly payment is P. Now let’s list out the money Emma own in the end of each month:

  • month0 = $10, 000
  • month1 = month0 X (1 + 0.25%) - P
  • month2 = month1 X (1 + 0.25%) - P
  • month3 = month2 X (1 + 0.25%) - P
    .
    .
    .
  • month11 = month10 X (1 + 0.25%) - P
  • month12 = month11 X (1 + 0.25%) - P

And remember, in the end of the 12th month, the loan is ended and Emma will pay off her loan, which means: month12 = 0.

Congratulations! You’ve gone through all the math you need to understand the mortgage calculation. The only thing left is to solve the above equations and we can leave it to calculator. Actually, there is a standard formula that solves these equations. But you don’t need those things. Understanding where they come from is more important.

There are a couple of things you can find through this:

  1. The interest from the your loan is calculated at each month, based on the money you own your bank at that point. Because this amount get less and less each month, the interest also get less and less.
  2. Paying more than your pre-calculated monthly payment is going to save you money, as long as you use the extra payment towards your principle. After this extra payment, you will own your bank less money and as a result, the interest of the next month will be less.

Hope this article brings values to you :)