What is a Mortgage? Understanding Payment Structures

What Is the Process of Paying off a Mortgage?

When you get a mortgage, you’re not just agreeing to pay back the amount you borrowed (principal). You also agree to pay interest on the money you still owe. How much you’ll pay in interest depends on a variety of factors, including your loan type, how much you borrowed, how long you have to pay it back, and the size of your down payment.

Each of your mortgage payments will be a combination of interest payments and principal repayments. You may be surprised to find that the majority of your initial payments go toward your interest, not your principal. This article will explain how mortgage payment structures work and why most of the initial payments go towards interest.

All About Mortgage Payments

Why Does More of My Mortgage Payment Go to Interest?

When you get approved for a mortgage, your lender will provide you with a payment schedule that has been created using an amortization formula. Mortgage amortization is the length of time it will take to repay the principal balance. This schedule will show you each of your monthly payments divided into principal and interest.

Your first payments will mostly go toward your interest, with only a small portion going toward your principal. As time goes on, you’ll notice that this pattern shifts. More money will go toward paying off the principal while the interest portion shrinks.

This is because the interest you pay is based on how much you still owe. As you chip away at your principal amount, the total amount you owe shrinks. Since interest is calculated based on that total amount, when it decreases, you end up paying less in interest.

Example of a Mortgage Payment Structure

Let’s look at the following example to better understand how mortgage payments work.

Say you have a fixed-rate mortgage for $360,000 with an interest rate of 5% and an amortization of 25 years. You would have monthly mortgage payments of $2,093.78 that would be divided in the following way:

• Your first payment would include a $1,484.61 interest payment and a $609.17 principal repayment. Your outstanding balance would become $359,390.83.
• The percentage of your payment going to principal and interest would change as soon as your second payment. The breakdown would become $1,482.10 for interest and $611.68 for the principal.
• 25 years and 300 payments later, your last payment would be split into $2,085.18 toward principal and $8.60 toward interest.

To figure out how much your mortgage payments will be, check out our mortgage calculator. It can show you a breakdown of what your money is going toward and your monthly balance.

If you have a variable-rate mortgage, it will likely follow a similar structure in which a large portion of your initial payments go to interest. However, your payment amount will also change as interest rates fluctuate.

What is a Mortgage Tipping Point?

The tipping point is the stage at which you start paying more principal than interest. Your interest rate, loan term, and pre-payments determine the timing of this phase.

If you have a 25-year mortgage with a fixed rate of 4%, you would reach your tipping point after 7 years and 6 months.

The lower your interest rate, the faster you will reach your tipping point. You can also accelerate this process by making pre-payments. These optional lump-sum payments go entirely toward your principal and must be paid on top of your mandatory monthly or biweekly payments. Moreover, pre-payments will decrease the interest you need to pay.

Before making any pre-payments, review the terms of your mortgage to find out how much you can pay and when to avoid paying pre-payment penalties.

What is a Mortgage Trigger Rate?

A trigger rate is the point at which your mortgage payments solely cover interest and can no longer contribute to reducing your principal. This situation can only happen to variable-rate mortgage holders with fixed payments; adjustable-rate and fixed-rate mortgage holders are not affected. A trigger rate occurs when the rate continuously increases, and the payments stay the same.

If this happens to you, your payments will no longer be bringing you closer to paying off your mortgage, meaning that this process will take longer than anticipated. This is called negative amortization.

What Is the Trigger Point on a Mortgage?

The trigger point occurs after the trigger rate and is the moment at which the balance you now owe is more than the original mortgage amount. If you reach your trigger point, you will need to speak with your lender to discuss ways to solve this issue.

You may need to increase your payments to get back on track. You can also make pre-payments or refinance your mortgage to lengthen your amortization.

How Do I Calculate My Mortgage Trigger Rate?

Your mortgage trigger rate will be provided in your mortgage contract. However, this sum will not take into account any pre-payments you have made, which increase the trigger rate.

To calculate your trigger rate, you will need to multiply the payment amount by the number of payments per year. Then, divide this sum by the balance owing and multiply that number by 100.

For example, if you pay $1,194 biweekly and your principal is $580,000, your trigger rate would be 5.35%. $1,194 per payment x 26 biweekly payments per year / $580,000 balance x 100 = 5.35%

Conclusion

When you receive a mortgage, you get charged interest as a percentage of your outstanding principal. This is the cost of getting a loan. Don’t be alarmed if you see that your first payment goes almost exclusively toward interest. This dynamic will shift, and more money will go to your principal as you chip away at your loan. However, be cautious of reaching your trigger rate and make sure you have enough savings to remedy the situation.

Call Stan at 604-202-1412 today to learn the fine details of homeownership and stay ahead of the game.