How the Mortgage Formula Determines Your Monthly Payments

When you start shopping for a home, at first you might think of your mortgage in terms of the size of the loan you will need. Ultimately though, what matters most is the size of the monthly payments you will have to fit into your budget for the next few decades.

How do you get from a total mortgage amount to a specific monthly payment? Understanding the mortgage formula involved will give you a conceptual feel for how different factors impact your payments. Knowing how to use a loan calculator will help you quickly run this type of calculation without having to master the complex math involved in mortgage formulas.

The Mortgage Formula: What Goes Into Your Monthly Payment

In the simplest terms, if you were to borrow a sum of money and pay it back in equal payments over 30 years, your monthly payments would consist of the amount borrowed divided by 360, with 360 representing the number of months in 30 years. So, in this over-simplified scenario, if you borrowed \$200,000 for a mortgage, your monthly payment would be \$200,000/360 = \$555.56.

However, in reality mortgage payments are complicated by two categories of things you have to pay in addition to the principal you borrowed: interest on the loan, and a variety of add-ons which, while not representing repayment of the loan, are related to the lender's interest in the property used to secure the loan.

Here's how interest payments, principal repayments, and those add-on items factor into your monthly mortgage payments:

Interest Payments

Interest payments represent your mortgage rate applied to the amount you owe over the period of time for which you have owed that money since the last interest payment. Since mortgage payments occur monthly, interest is applied to the amount you owe in monthly increments. The most important part to recognize about how this works is that interest payments on a mortgage are largest in the first month of the loan, when you still owe the full amount borrowed. Then, as you start to repay part of the loan, the principal outstanding is reduced and thus when the interest rate is applied to that declining principal, the interest component of your monthly payment gradually becomes smaller and smaller.

Principal Repayments

Most mortgages are designed to split the loan payments into equal monthly increments. As described above, since you will owe more at the beginning of the mortgage, this means the income component of those monthly payments will be larger. Then, as principal is repaid, the interest portion of the payment is reduced and the principal portion grows. This is why principal repayment (and thus the accumulation of equity in your home) happens slowly in the early years of a mortgage, but accelerates sharply in the later years of the loan.

Depending on the type of mortgage you get, you might have to pay for mortgage insurance, which protects lenders against borrowers who don't repay their loans. In addition, since your loan is secured by the home, the lender has an interest in making sure the value of that property is protected by maintaining adequate homeowner's insurance and keeping up with property tax payments. Thus, often times lenders will insist that payment for these items should be made through them, so these add-on payments will add to the monthly amount you are obligated to send the mortgage company.

Using a Mortgage Calculator

In particular, calculating monthly interest on a principal amount that declines over time and figuring out how to balance changing interest and principal components into equal monthly payments over the life of the loan is a complicated process. Fortunately, mortgage calculators allow you to instantly see how specific loan terms would translate into monthly payments.

Take a look at LendingTree's mortgage calculator and you will see there are spaces on the left of the screen for you to enter a few key assumptions. Enter figures that apply to your situation, and click on the "Calculate" button. In the top-right hand portion of the screen the calculator will list your estimated monthly payment in large numbers, with the components of that payment broken down underneath.

The LendingTree calculator will make these estimates based on the credit and location information you listed, but if you want to fine-tune assumptions like mortgage rate, loan length, or property tax, simply click the arrow to the right of the word "Assumptions" and the applicable assumptions will display underneath. You can then alter those assumptions to better fit the facts of your situation.

One of the key benefits of mortgage calculators is that they make it easy to test a variety of changes to your mortgage assumptions. What would happen if you borrowed \$25,000 more for your home? What if you chose a 15-year rather than a 30-year mortgage? What if mortgage rates rise by 30 basis points? Using the mortgage calculator, you can instantly see the effect these changing variables would have on your monthly payments.

Using a little trial-and-error by changing assumptions, you can arrive at a mortgage payment that fits into your budget, and that is the most important outcome of the mortgage formula: finding an amount you can afford.

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