I often hear people express with dismay that 90% of their mortgage payment goes toward interest and that they’re not building much equity, especially at the beginning of their loan.  As many readers know, I recently refinanced and was surprised to look at one of my first few statements to realize that more than 2/3rds of my loan payment was going towards principal.  It made me wonder what all these folks were talking about, so I thought I’d look into it a little closer.


Let’s Ignore The Escrows

To make things easy, I’m going to ignore the costs of taxes and insurance.  While those are obvious costs of being a homeowner, they really shouldn’t be considered part of your mortgage, since you still have to pay them even after the mortgage is “paid off.”  But if you were to include them, the percentage of your payment going toward principal would obviously be lower than my examples demonstrate below.

Methods

I decided to look at two types of loans, a 15 year fixed loan and a 30 year fixed loan, and to consider what percentage of that payment was going toward principal.  I looked at both the first payment, as well as the 120th payment (10 years into the loan.)  I also considered how our currently low interest rate environment would affect the results.  I was curious which would have the bigger effect- decreasing the length of the mortgage or decreasing the interest rate (although they generally travel together of course.)  Here is what I found using the spreadsheet functions “Payment” (PMT) and “Principal Payment” (PPMT).  The graph shows the percentage of the payment going toward principal.

Rate 15Y 1st PMT 15Y 120th PMT 30Y 1st PMT 30Y 120th PMT
3% 64% 86% 41% 55%
6% 41% 74% 17% 30%
9% 26% 63% 7% 17%

Results

As you can see, the idea that 90% of your payment goes toward interest only applies to a 30 year loan with an interest rate of 8% or higher, and then only for the first few years.  If you can get a lower interest rate, and/or shorten the course of the loan, your first payment can be composed of as much as 64% principal, which increases to as much as 86% principal after 10 years.  It is also interesting that decreasing the interest rate by 3% has about the same effect on the percentage as cutting the loan term in half.  Decreasing the interest rate by 6% has about the same effect as paying down the loan for a decade.

Conclusions

Anyone whose mortgage payment is 90% interest needs to refinance.  Refinancing to a lower rate (while keeping the term the same), paying extra principal, and using a shorter mortgage are good ways to minimize the interest costs of buying a house, although doing so doesn’t necessarily leave you better off financially if the opportunity cost is too high.

What do you think?  Were you surprised by the results?  Comment below!