Paying Down the Principal

• The length of the loan determines how much principal you will pay down every month. In a traditional 30-year mortgage, you will make 360 payments in which the amount of principal paid goes up every month as the balance goes down, and the interest due goes down. A shorter loan, such as a 15-year mortgage, will allow you to pay off the loan even faster.
  
  

Understanding Interest

• The interest on the loan is charged based on its coupon rate. This rate, which, as of the summer of 2010 would be around 5.25%, corresponds to the percentage of the loan's balance that has to be paid every year. Since your monthly payments reduce the loan's balance, the amount on which you have to pay interest goes down, meaning that you pay a little less interest and a little more principal every month. This process of allocating your money to interest and principal is called amortization.
  
  

A Real World Example

• Making your mortgage payment.Making a financial plan image by Allen Stoner from Fotolia.com
  
  The best way to understand this process is to take a real world example. Let us assume that you take out a $200,000 mortgage at 5.25 percent, amortized over 30 years. The monthly payment would be $1,104.41. In the first month, you would pay $875.00 in interest and $229.41 toward the balance of the loan. At 10 years in, you would make the same payment, but only $717.05 would go to interest with $387.36 going toward principal. At 25 years in, the breakdown would be $846.21 in principal and $258.19 in interest. In every case, the monthly payment is the same. You can calculate this yourself with a financial calculator or with a spreadsheet, or you can ask your lender to provide an amortization sheet.
  
  

Paying Interest Without Principal

• In recent years, lenders have invented the interest-only loan. In this loan, you pay only the interest due and no principal. Given the above example, the interest-only monthly payment would be only $875.00. Although this looks like a great deal, you should bear in mind that even after making your payments to the bank, you will still owe them the original $200,000 and will need to refinance in the future. If you cannot refinance the loan when it becomes due, you can lose your house. Even worse than the interest-only loan is the negative amortization loan, where your payment is not enough to even cover your interest, meaning that your loan balance actually goes up, leaving you deeper in debt every month.
  
  

Beyond Principal and Interest

• There is more to many mortgage payments than just principal and interest. Many lenders will talk about a PITI payment, which refers to principal, interest, taxes and insurance. Mortgages with a PITI payment structure will frequently have an escrow account. You pay an amount above and beyond your P & I payment into that account, which is then used to pay for your property taxes, property insurance and, if necessary, PMI.