Mortgage Payments: a Primer

September 17, 2007, Revised January 3, 2011

The one thing that virtually all borrowers know about their mortgages is the amount of the initial scheduled payment. This is the amount they are obliged to pay each period under the terms of the mortgage contract. They know that failure to pay that amount is a violation of the contract, leading to late charges, delinquency reports and ultimately to foreclosure.

While borrowers know the amount, they are often hazy about how it is calculated and what it includes. I will illustrate the possibilities related to a $100,000 loan at 6%.

In the simplest possible case, the scheduled payment includes only interest until the final payment, when it includes repayment of the balance. The interest payment each month is .06 /12, or .005, multiplied by $100,000, which equals $500. The final payment, assuming the borrower paid only interest throughout, would be $100,500.

Most mortgages written during the 1920s were of this type, usually with terms of 5 or 10 years. Their weakness is that they must be refinanced at term, which during the depression of the 1930s became very difficult because property values and borrower incomes had fallen. The notion took hold that it was prudent for borrowers to pay down the balance over time by making a mortgage payment larger than the interest. This additional amount is called the principal payment.

The principal payment is always a residual, the total payment less the interest. If the borrower in the example paid $600, the $500 of interest would be deducted, leaving $100 as the principal payment. If the borrower paid $700, the principal payment would be $200.

Including principal in the scheduled payment requires a rule for determining what that payment is. The most obvious rule is to pay back equal amounts of principal every month. If our sample loan is for 30 years, we divide $100,000 by 360 to get a principal repayment of $277.78 a month.

Loans of this type have existed, most recently in New Zealand, but they have a serious drawback. The scheduled payment that includes a fixed amount of principal every month starts high – too high for many borrowers -- and ends low because of the decline in interest. In month one, the scheduled payment is $277.78 plus $500, or $777.78. In month 360, it is $277.78 plus $1.39, or $279.17.

So some unknown pundit reasoned as follows: "If payments beginning at $777.78 and declining every month to $279.17 will pay off this loan, there must be some amount in-between which, if made every month without change, would do the same." The reasoning is correct, the amount ($599.56 in my example) is called the fully amortizing payment.

The fully amortizing payment is calculated from an equation shown in Formulas. But you don’t need the equation, financial calculators have programmed it so you can derive an answer in seconds, whereas solving the equation takes minutes.

If the interest rate does not change, the fully amortizing payment is constant over the life of the loan. However, the part going to interest declines, and the part going to principal rises every month. This is the source of a widespread fallacy that mortgages are "front-end loaded", see Is Interest on Home Mortgages Front-End Loaded?

After World War II, virtually all mortgages carried fully-amortizing payments. However, borrowers generally seek lower initial payments, and lenders seek to accommodate them if possible.

The only way to reduce the initial payment is to reduce the principal payment -- principal is the only payment component that has any "give" in it. Lenders will not forgo interest but they may allow borrowers to delay making principal payments. This was the prevailing practice in the 1920s, the practice largely ended in the 1930s, and then it returned in recent years with interest-only options and options ARMs.

On mortgages with an interest-only option, the scheduled payment is the interest payment for the length of the interest-only period, usually 5 to 10 years. After that, the scheduled payment becomes the fully-amortizing payment.

On option ARMs, borrowers have the rare privilege of selecting their own scheduled payment during the first 5 or 10 years. The can select the fully-amortizing payment over either 15 or 30 years, the interest-only payment, or a "minimum" payment that is less than the interest. Most borrowers select the last, and sometimes find themselves in trouble when their scheduled payment increases in future years. See Tutorial on Option ARMs.

The scheduled payment may not be limited to interest and principal. The monthly mortgage insurance premium, if there is one, will be included. If the borrower has agreed to escrow property taxes and homeowners insurance, most lenders treat the monthly escrow payments as if they are also part of the scheduled payment; if the escrow payment is short, the payment is considered delinquent. A borrower can start down a slippery path to foreclosure by failing to pay required escrows. See Escrow Abuse and Manufactured Foreclosures.

## The Scheduled Mortgage Payment

The one thing that virtually all borrowers know about their mortgages is the amount of the initial scheduled payment. This is the amount they are obliged to pay each period under the terms of the mortgage contract. They know that failure to pay that amount is a violation of the contract, leading to late charges, delinquency reports and ultimately to foreclosure.

While borrowers know the amount, they are often hazy about how it is calculated and what it includes. I will illustrate the possibilities related to a $100,000 loan at 6%.

## Interest-Only as the Scheduled Payment

In the simplest possible case, the scheduled payment includes only interest until the final payment, when it includes repayment of the balance. The interest payment each month is .06 /12, or .005, multiplied by $100,000, which equals $500. The final payment, assuming the borrower paid only interest throughout, would be $100,500.

Most mortgages written during the 1920s were of this type, usually with terms of 5 or 10 years. Their weakness is that they must be refinanced at term, which during the depression of the 1930s became very difficult because property values and borrower incomes had fallen. The notion took hold that it was prudent for borrowers to pay down the balance over time by making a mortgage payment larger than the interest. This additional amount is called the principal payment.

## Determining the Principal Payment

The principal payment is always a residual, the total payment less the interest. If the borrower in the example paid $600, the $500 of interest would be deducted, leaving $100 as the principal payment. If the borrower paid $700, the principal payment would be $200.

Including principal in the scheduled payment requires a rule for determining what that payment is. The most obvious rule is to pay back equal amounts of principal every month. If our sample loan is for 30 years, we divide $100,000 by 360 to get a principal repayment of $277.78 a month.

## Equal Monthly Principal Payments

Loans of this type have existed, most recently in New Zealand, but they have a serious drawback. The scheduled payment that includes a fixed amount of principal every month starts high – too high for many borrowers -- and ends low because of the decline in interest. In month one, the scheduled payment is $277.78 plus $500, or $777.78. In month 360, it is $277.78 plus $1.39, or $279.17.

So some unknown pundit reasoned as follows: "If payments beginning at $777.78 and declining every month to $279.17 will pay off this loan, there must be some amount in-between which, if made every month without change, would do the same." The reasoning is correct, the amount ($599.56 in my example) is called the fully amortizing payment.

## The Fully-Amortizing Payment

The fully amortizing payment is calculated from an equation shown in Formulas. But you don’t need the equation, financial calculators have programmed it so you can derive an answer in seconds, whereas solving the equation takes minutes.

If the interest rate does not change, the fully amortizing payment is constant over the life of the loan. However, the part going to interest declines, and the part going to principal rises every month. This is the source of a widespread fallacy that mortgages are "front-end loaded", see Is Interest on Home Mortgages Front-End Loaded?

After World War II, virtually all mortgages carried fully-amortizing payments. However, borrowers generally seek lower initial payments, and lenders seek to accommodate them if possible.

The only way to reduce the initial payment is to reduce the principal payment -- principal is the only payment component that has any "give" in it. Lenders will not forgo interest but they may allow borrowers to delay making principal payments. This was the prevailing practice in the 1920s, the practice largely ended in the 1930s, and then it returned in recent years with interest-only options and options ARMs.

**Scheduled Payments on New Types of ARMs**

On mortgages with an interest-only option, the scheduled payment is the interest payment for the length of the interest-only period, usually 5 to 10 years. After that, the scheduled payment becomes the fully-amortizing payment.

On option ARMs, borrowers have the rare privilege of selecting their own scheduled payment during the first 5 or 10 years. The can select the fully-amortizing payment over either 15 or 30 years, the interest-only payment, or a "minimum" payment that is less than the interest. Most borrowers select the last, and sometimes find themselves in trouble when their scheduled payment increases in future years. See Tutorial on Option ARMs.

## Other Components of the Scheduled Payment

The scheduled payment may not be limited to interest and principal. The monthly mortgage insurance premium, if there is one, will be included. If the borrower has agreed to escrow property taxes and homeowners insurance, most lenders treat the monthly escrow payments as if they are also part of the scheduled payment; if the escrow payment is short, the payment is considered delinquent. A borrower can start down a slippery path to foreclosure by failing to pay required escrows. See Escrow Abuse and Manufactured Foreclosures.

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