Mortgage Interest Explained
Understanding interest calculation is the key to understanding your mortgage.
Most homeowners make 360 monthly payments over 30 years without truly understanding where their money goes. This guide reveals the mathematical principles behind mortgage interest—how it's calculated, why early payments are mostly interest, and how extra payments disrupt the formula in your favor.
What you'll learn:
The exact formula lenders use to calculate monthly interest
Why your first payment is 81% interest, but your last is 9% interest
How compound interest affects your total cost
The mathematical proof of why extra payments save so much
When the interest-to-principal ratio flips
Real calculations using a $378,000 loan example
The Monthly Interest Formula
Every month, your lender calculates interest using a simple formula:
The Formula
Monthly Interest = (Current Balance × Annual Rate) ÷ 12That's it. No complexity, no hidden tricks. Your monthly interest is your current balance multiplied by your annual rate, divided by 12 months.
Example Calculation: Payment #2
Now your balance is lower, so interest charges decrease:
Calculate monthly interest:
Your second payment: $2,175.98 (same amount)
To interest: $1,770.07 (81.3%)
To principal: $405.91 (18.7%)
New balance: $377,595.90 - $405.91 = $377,189.99
Notice: Interest dropped by $1.81, so principal increased by $1.81. Same payment, different allocation.
30-Year Progression (Selected Milestones)
Payment #1 (Year 1):
Payment #60 (Year 5):
Payment #120 (Year 10):
Payment #180 (Year 15):
Payment #240 (Year 20):
Payment #300 (Year 25):
Payment #360 (Year 30, final):
The pattern: As balance decreases, interest shrinks and principal grows—but your total payment stays constant.
The Interest-to-Principal Crossover Point
The crossover point is when more of your payment goes to principal than to interest.
For our $378,000 loan at 5.625%, the crossover happens around payment #218 (year 18):
Payment #218:
Principal finally exceeds interest. From this payment forward, you're conquering more loan than you're paying the lender.
Factors Affecting Crossover Timing
Higher interest rate → Later crossover
7% rate: Crossover around year 20-21
3% rate: Crossover around year 14-15
Extra payments → Earlier crossover
$200/month extra: Crossover around year 12-13
$500/month extra: Crossover around year 8-9
Lower original loan → Earlier crossover (mathematically similar curve, but shorter timeline)
How Interest Compounds (Or Doesn't)
Common misconception: "My mortgage compounds monthly/daily/continuously."
Truth: Standard fixed-rate mortgages use simple interest, not compound interest. Interest is calculated on the principal balance only, not on accumulated interest.
Simple Interest (What Mortgages Use)
Interest is charged on principal. Paid interest doesn't generate additional interest.
If Mortgages Used Compound Interest (They Don't)
Hypothetical compound interest mortgage:
30-year $378,000 loan at 5.625% compounded monthly:
Total paid: $970,000+
Interest: $592,000+
Actual simple interest mortgage:
Total paid: $782,351
Interest: $404,351
Difference: Compound interest would cost $188,000 more.
Fortunately, mortgages don't compound. Interest is recalculated monthly based on remaining principal only.
How Extra Payments Save Interest
Mathematical principle: Extra payments reduce principal immediately, which reduces all future interest calculations.
The Savings Multiplier
Example: $500 extra payment in month 1
Without extra payment:
Payment #1: $378,000 balance → $1,771.88 interest
Payment #2: $377,595.90 balance → $1,770.07 interest
Payment #3: $377,189.99 balance → $1,768.26 interest
Continues for 360 payments...
With $500 extra payment:
Payment #1: $378,000 balance → $1,771.88 interest + $500 extra = $904.10 total principal
Payment #2: $377,095.90 balance → $1,767.73 interest (saves $2.34 vs without)
Payment #3: $376,690.65 balance → $1,765.81 interest (saves $2.45 vs without)
Savings compound every month for remaining life of loan...
Total interest saved from $500 extra in month 1: ~$1,840
Your $500 eliminates $1,840 of future interest. That's 3.68x return.
Why Earlier Payments Save More
$500 extra in payment #1:
Reduces balance by $500
Saves interest for 359 remaining months
Total savings: ~$1,840
$500 extra in payment #180 (year 15):
Saves interest for 180 remaining months
Total savings: ~$920
$500 extra in payment #300 (year 25):
Saves interest for 60 remaining months
Total savings: ~$140
Same $500, vastly different savings depending on timing.
The True Interest Cost Example
Scenario: No Extra Payments
Loan: $378,000 at 5.625% for 30 years Monthly payment: $2,175.98
Total payments: $2,175.98 × 360 = $783,352.80 Principal repaid: $378,000 Total interest: $783,352.80 - $378,000 = $405,352.80
You pay more in interest than you borrowed in principal.
Scenario: $200/Month Extra
Loan: $378,000 at 5.625% Regular payment: $2,175.98 Extra payment: $200/month
New payoff: 286 months (23.8 years) Total regular payments: $2,175.98 × 286 = $622,330.28 Total extra payments: $200 × 286 = $57,200 Grand total paid: $679,530.28
Principal repaid: $378,000 Total interest: $679,530.28 - $378,000 - $57,200 = $301,530.28
Interest saved: $405,352.80 - $301,530.28 = $103,822.52
By paying $57,200 extra, you eliminate $103,822.52 in interest. ROI: 1.81x (81% return).
Interest Calculation Timing
When is interest calculated?
Most lenders calculate interest daily but charge monthly.
Daily Accrual Method
Example:
Balance: $378,000
Annual rate: 5.625%
Daily rate: 0.05625 ÷ 365 = 0.000154109589
Daily interest: $378,000 × 0.000154109589 = $58.25
If 30 days in month: $58.25 × 30 = $1,747.50
Note: This is slightly different from the simple monthly calculation ($1,771.88) because of the 30-day vs 365/12-day difference. Most lenders use 365-day calculation.
If you make extra payments mid-month:
Interest stops accruing on that principal immediately for the remainder of the month.
You save a few dollars that month, which compounds into larger savings over the life of the loan. Best practice: Make extra payments as early in the month as possible to minimize interest accrual.
Interest and APR: What's the Difference?
Interest Rate (Note Rate): The rate used to calculate your monthly payment. This is the number you enter in PayOff Pro.
APR (Annual Percentage Rate): Includes interest rate PLUS upfront costs (origination fees, points, closing costs) spread over loan life.
Example:
Amount: $378,000
Interest rate: 5.625%
Closing costs: $7,500
APR calculation: Includes $7,500 spread over 30 years APR: ~5.725% (higher than interest rate because of fees)
For PayOff Pro: Use your interest rate (note rate), not APR. APR includes one-time costs that don't affect monthly interest calculation.
Fixed vs Adjustable Rate Interest
Fixed-Rate Mortgages
Interest rate never changes. If you lock in 5.625%, that's your rate for 30 years.
Benefit: Predictable payments. PayOff Pro calculates exact payoff schedule.
Drawback: If rates drop, you're stuck unless you refinance.
Adjustable-Rate Mortgages (ARMs)
Interest rate changes periodically based on market index (e.g., SOFR, LIBOR).
Common structure: 5/1 ARM
Fixed for first 5 years
Adjusts annually after that
PayOff Pro usage: Enter current rate for projections. Understand projections will change when rate adjusts.
❗Note: PayOff Pro is optimized best for fixed rate mortgages only although you may workaround with ARMs its less desirable and much of it benefits is lost if used for that type of rate.
Common Interest Calculation Mistakes
Mistake #1: Using APR Instead Of Interest Rate
Wrong: "My APR is 5.875%, so that's the rate for my monthly payment."
Right: Use the note rate (interest rate) from your loan documents, not APR.
Mistake #2: Including Escrow In Interest Calculation
Wrong: "My payment is $3,200, and $1,800 is interest."
Right: Separate principal + interest payment from escrow (taxes/insurance). Interest is only calculated on principal + interest portion.
Mistake #3: Thinking Interest "Piles Up"
Wrong: "I haven't made a payment in 2 months, so my interest is compounding."
Right: Interest accrues daily on principal balance. You owe simple interest on the outstanding principal for the period overdue, not compound interest.
Mistake #4: Paying Extra But Not Specifying Principal
Wrong: "I sent $3,000 payment instead of $2,175.98. It should all reduce principal."
Right: Tell your lender to apply extra to principal. Otherwise, they might apply it to future payments, which doesn't save interest.
Key Insights
Interest is recalculated every month based on your current balance. Lower balance = less interest.
Early payments are mostly interest because you owe a lot of principal, generating high interest charges.
Late payments are mostly principal because you owe little principal, generating low interest charges.
Extra payments disrupt the formula by reducing principal faster than scheduled, causing cascading interest savings.
Timing matters: Earlier extra payments save exponentially more interest than later ones.
Simple interest, not compound: Your mortgage doesn't charge interest on interest. Interest is only calculated on remaining principal.
Related Topics
Extra Payments Now that you understand interest calculation, see why extra payments have such powerful impact. Learn more: Why Extra Payments Matter →
Amortization Understand how fixed payments result in changing principal/interest ratios. Learn more: Amortization Explained →
True Cost Calculate the total interest you'll pay over your loan's life. Learn more: True Cost of Borrowing →
Understanding Is Power
Most homeowners make mortgage payments for decades without understanding this math. Now you do.
With this knowledge, you can:
Calculate your own monthly interest
Predict exactly how extra payments affect your loan
Understand why earlier payments save more
Make informed decisions about refinancing
Verify your lender's calculations
PayOff Pro handles these calculations automatically, but understanding the principles empowers better financial decisions.
Last Updated: 2025-10-16 Guide Version: 1.0 App Version: PayOff Pro v1.0
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