What is compound interest on a mortgage?

Mortgages are loans, and as such, consumers must pay interest for the period that they are borrowing the money. For mortgage loans, this is expressed as an interest rate, such as 6.0%.  For example, you may have a $125,000 mortgage loan with a 6.0% interest rate. The cost that you must pay in order to borrow that money is 6.0% of the principal. So. how come you end up paying much, much more than $125,000 times 0.06 (which equals $7,500)? The answer is compounding interest. This is in contrast to simple interest, which is a one-time finance charge based on the principal. If mortgage loans were simple interest loans, you would pay very little in the long run. But in reality for the mortgage lender to make a profit, you are charged compound interest.

Compounding interest occurs when you are charged a finance fee based on the interest rate, and the interest is then added back on to the principal. The next time the finance charge is levied, it’s based on this new principal. You should already be familiar with the concept of compounding interest with your savings account. Over time, the amount of interest that gets added increases exponentially as the principal continues to grow.

The interest on mortgage loans are compounded monthly. That means that each month, the bank takes your interest rate and levies a finance charge on your remaining balance. Your monthly mortgage payment consists of the interest that’s accrued on your loan, plus a portion that gets applied to your principal in order to pay it down. Because your pay a different amount of interest each month, the amount of your monthly mortgage payment that goes towards your principal is different each month.

A mortgage amortization schedule shows you how much interest and how much towards the principal you’ll be paying each month. By using a mortgage calculator, you can determine the fixed amount you’ll need to pay each month in order to have your loan completely paid off by the end of your predetermined mortgage term. Because your principal changes each month, it’s not as simple as taking your interest rate and multiplying it by the number of months in your mortgage term in order to determine the amount of interest you’ll pay. The actual formula used is usually:

M = P( [I(1+I)^N]/[(1+I)^N-1])

Where M = your monthly payment

P = Mortgage principal

I = monthly interest

and N = number of months (loan term)

Note that the true amount that you’ll pay each month also includes your real estate taxes and your home insurance premiums. You are not charged interest on this portion of your monthly mortgage payment.

If you are curious as to exactly how your mortgage payment breaks down and how much interest you’ll be paying in the long run, take a look at your mortgage payment schedule or mortgage statement given to you by your mortgage lender each year.