How does paying down a mortgage work?
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The amount you borrow with your mortgage is called the principal or the mortgage balance. Each month, part of your monthly payment goes toward paying off the principal and part pays interest on the loan. Interest is what the lender charges you for lending you money.
Most people’s monthly payments also include additional amounts for taxes and insurance.
The part of your payment that goes to principal reduces the amount you owe on the loan and builds your equity. The part of the payment that goes to interest doesn’t reduce your balance or build your equity. So, the equity you build in your home is much less than the sum of your monthly payments.
With a typical fixed-rate loan, the combined principal and interest payment does not change over the life of your loan, but the amounts that go to principal rather than interest do change.
How does mortgage amortization work?
In the beginning of your mortgage term, you owe more interest, because your loan balance is still high. Most of your monthly payment is applied to the interest you owe, and the remainder is applied to paying off the principal. Over time, as you pay down the principal, you owe less interest each month, because your loan balance is lower. This means that over time, more of your monthly payment goes to paying down the principal. Near the end of the loan, you owe much less interest, and most of your payment goes to pay off the last of the principal. This process is known as amortization.
Lenders use a standard formula to calculate the monthly payment that allows for just the right amount to go to interest and principal, to pay off the loan precisely at the end of the term.