How Mortgage Payments Are Calculated: Principal, Interest, Tax and Insurance

The amortisation formula

A fixed-rate loan is repaid in equal monthly instalments. The instalment M is chosen so that, after the last payment, the balance is exactly zero:

M = P × r(1 + r)^n ÷ ((1 + r)^n − 1)

P = amount borrowed
r = annual interest rate ÷ 12   (6.5% → 0.0054167)
n = number of monthly payments (30 years → 360)

For our example, P is $320,000 (the $400,000 price minus the $80,000 down payment). Plugging in gives a principal-and-interest payment of $2,022.62 a month. Over 360 payments that is $728,142 in total, of which $408,142.36 is interest — more than the amount borrowed.

Why the first payments are mostly interest

Each month, interest is charged on the balance still owed: balance × r. Whatever is left of the fixed payment reduces the balance. At the start the balance is at its largest, so interest takes most of the payment.

In the first month of our example, interest is $320,000 × 0.0054167 = $1,733.33, leaving only $289.28 to pay down the loan. As the balance shrinks, the interest portion falls and the principal portion grows. The two cross in month 233 — almost twenty years in — after which most of each payment finally goes to principal. This is why selling or refinancing in the first few years leaves you owing almost as much as you borrowed.

Adding property tax and homeowners insurance

Most lenders collect property tax and insurance monthly and pay the bills for you from an escrow account. That turns principal and interest into PITI: principal, interest, taxes and insurance.

• Property tax: assume 1.1% of the purchase price a year, a typical US figure → $4,400 a year, or $366.67 a month. Real rates range from well under 0.5% to over 2% depending on the county.
• Homeowners insurance: assume $1,800 a year → $150 a month.
• PITI: $2,022.62 + $366.67 + $150.00 = $2,539.28 a month.

Escrow payments can change every year even on a fixed-rate loan, because tax assessments and insurance premiums change. Only the principal-and-interest part is truly fixed.

Private mortgage insurance (PMI)

With less than 20% down on a conventional loan, lenders usually require PMI, which protects the lender — not you — if you default. It is typically priced as a percentage of the loan per year.

Put 10% down on the same house and the loan becomes $360,000. Principal and interest rise to $2,275.44, and PMI at 0.5% a year adds $150 a month, for a total of $2,942.11 with tax and insurance — about $400 more than the 20%-down version.

Under the US Homeowners Protection Act, you can ask the lender to cancel PMI once the balance reaches 80% of the home’s original value, and it must end automatically at 78% if your payments are current. FHA loans follow different rules: their mortgage insurance premium often lasts for the life of the loan unless you refinance.

How term and extra payments change the total

• 15-year loan: 15-year mortgages usually carry lower rates. At 5.75%, the same $320,000 costs $2,657.31 a month — $634.69 more than the 30-year — but total interest falls to $158,316.21, saving about $250,000.
• Extra principal: paying $200 a month on top of the 30-year payment clears the loan in 281 months (about 23.4 years) and saves $105,428.67 of interest. Make sure extra payments are applied to principal, and check the loan has no prepayment penalty.
• Biweekly plans: paying half the monthly amount every two weeks makes 26 half-payments, or 13 full payments a year — the same effect as one extra payment annually. You can get it without a third-party plan by adding one-twelfth of a payment each month.

What the formula leaves out

• Closing costs — typically 2–5% of the price for fees, title insurance and prepaid items — are paid up front, not in the monthly payment, unless rolled into the loan.
• HOA or condo fees are paid separately but count toward what a lender considers your housing cost.
• Maintenance and repairs, often budgeted at 1–2% of the home’s value a year, are not part of any loan payment but are part of what owning costs.

This guide is for education, not financial advice. Rates, fees, insurance and tax rules vary by lender and location, so ask lenders for an official Loan Estimate and compare those line by line.

Reading a Loan Estimate

In the US, lenders must give you a standard three-page Loan Estimate within three business days of an application, which makes offers easy to compare side by side. Page 1 shows the loan amount, interest rate, monthly principal and interest, and whether the rate can change or there is a prepayment penalty. It also shows projected payments including estimated escrow. Page 2 itemises closing costs. Page 3 shows the APR and the total interest percentage — how much interest you pay over the life of the loan as a percentage of the amount borrowed.

Compare the interest rate and APR together. A lower rate with a noticeably higher APR usually means larger fees or points.

Buying discount points

Lenders often let you pay “points” at closing to lower the rate: one point costs 1% of the loan amount. On our $320,000 loan, one point is $3,200. If it lowered the rate from 6.5% to 6.25%, the monthly payment would fall by $52.32, so it would take about 61 months — just over five years — for the saving to repay the cost. Points make sense if you expect to keep the loan well past that break-even point; if you might sell or refinance sooner, they rarely pay off.