If you’re getting a home loan in Champaign County, you’ll likely hear the terms principal and interest. In a home loan, the principal is the amount you borrow, and the interest is what you pay every month.
The principal of a mortgage is calculated by subtracting the down payment from the final sales price of the home you are buying. When you borrow money, interest begins to accumulate on the principal.
In a mortgage payment, interest is the second component. You’re paying your mortgage lender to give you a loan, which is reflected in your interest. Most lenders will calculate your mortgage rate in terms of an annual percentage rate or APR. APR is what you pay on your loan per year in interest. If you borrow $200,000 and your APR is 5%, you’re paying $10,000 a year in interest.
Your principal is high at the start of your loan, so during this time, your monthly payment is primarily going towards paying your interest.
There is a significant difference in the amount you ultimately pay for your loan based on a few percentage points of interest. The monthly payment on a $150,000 loan with a 4% interest rate would be $716 if you borrowed $150,000 over 30 years. A 6% interest rate would result in a monthly payment exceeding $899 if you had the same loan.
A difference of just 2% in interest rates, for example, can make a difference of tens of thousands of dollars in how much you pay in interest over the life of your loan.
Part of your loan payment will be applied to interest and fees before it’s reduced to principal when you make a payment. The lender will use the same formula to pay the interest if you make additional monthly payments. The lender adds up interest accrued during the month, using a part of your payment to pay accrued interest before it’s then applied to your principal.
What is a Principal-Only Payment?
When you make a principal-only payment, your entire payment goes toward reducing your principal. Your interest charges are lower when your principal is reduced, since interest is calculated based on the principal.
With principal-only payments, you can pay off debt faster.
It is not possible to make a principal-only payment with every lender, and some will allow you to make additional payments during the month, but you must specify that they go toward only the principal.
The additional principal payment on a home loan goes beyond your monthly mortgage payment and is applied directly to your principal mortgage amount.
Even if you make principal-only payments, your monthly payments remain the same. Your loan will be more affordable over its lifetime if you save on interest.
You might want to recast your mortgage if you want lower monthly payments.
Mortgage Recasting
As a final note, recasting your mortgage can save you money by reducing your interest costs and reducing the number of payments you need to make until your mortgage is paid off.
You make a lump-sum payment towards your loan’s principal balance with a mortgage recast. Your lender amortizes your mortgage, reflecting your lower balance. You can lower your monthly payments because your principal went down, but your term and interest rates stay the same.
One example of when someone might recast a mortgage is if they bought a new home before selling their old one. Then, once they sell their previous home, they can use that money to recast their new mortgage.
If you get a bonus or windfall of money for some reason, you might also want to do a mortgage recast. Many lenders will charge a servicing fee for this, but not usually more than a few hundred dollars.
Not every lender will offer this option, and some types of loans aren’t eligible.
You can’t have a government-backed loan and it must meet minimum standards for principal reduction. For example, you usually have to make a minimum payment of $5,000. You’ll also probably need to meet equity requirements, and you have to meet requirements set by your lender for your payment history.
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