Why Do Most of My Mortgage Payments Start Out as Interest?

The amount of a mortgage payment is composed of a combination of interest and principal repayment. Over the life of the mortgage, the proportion of interest to principal will change.

Initially, the homeowner's payment will be primarily interest, with a small amount of principal included. As the mortgage matures, the principal portion of the payment will increase and the interest portion will decrease. This is because the interest charged is based on the current outstanding balance of the mortgage, which decreases as more principal is repaid. The smaller the mortgage principal, the less interest charged.

For example, take a simple mortgage for $100,000 at an interest rate of 4% annually and a time to maturity of 24 years. The yearly mortgage payment is $6,558.68. The first payment will include an interest charge of $4,000 ($100,000 x 4 percent) and a principal repayment of $2,558.68 ($6,558.68 - $4,000). The outstanding mortgage balance after this payment is $97,441.32 ($100,000 - $2,558.68). The next payment will be equal to the first, $6,558.68, but it will now have a different proportion of interest to principal. The interest charge for the second payment will be $3,897.65 ($97,441.32 x 4 percent) while the principal prepayment will be $2,661.03 ($6,558.68 - $3,897.65).

The principal portion of the second payment is around $100 larger than the first. This occurs because the homeowner has paid money towards the principal amount—reducing it—and the new interest payment is calculated on the lower principal amount. Towards the end of the mortgage, the payments will be primarily principal repayments.

This is a basic example using a traditional plain vanilla loan. With exotic mortgages, homeowners can Choose Your Monthly Mortgage Payments. 

Although the interest portion decreases each month, the mortgage payments themselves do not decrease over time. More money is going toward the principal balance, which is fully amortized over the life of the loan. As a result, as the years go by, more of the homeowner's payment goes toward principal, accelerating the rate at which the homeowner builds equity and decreasing the amount owed. During year 30 of a 30-year fixed mortgage, the homeowner increases his equity position by much more with each payment made compared to the payments made in years one and two.

However, there are some specific situations in which mortgage payments can decrease. 

An adjustable-rate mortgage (ARM) may have decreasing payments over time. With this type of mortgage, the interest rate fluctuates based on an index that reflects the cost to the lender of borrowing on the credit markets. The payments on an ARM may decrease if the loan's benchmark rate decreases over the course of the loan. However, an ARM has an equal potential for payments to increase, sometimes substantially. The loan documents stipulate how much the interest rate may increase each year as well as the maximum it can increase over the entire term of the loan.

A borrower who must pay mortgage insurance during the early years of a loan might see her mortgage payment decrease over time. Most mortgage companies cap loans at 80% of the purchase price or the home's value, whichever is less, and the borrower is expected to come up with the other 20% as a down payment. This loan-to-value [LTV] ratio is designed to protect the lender if the home's value drops and the borrower owes more than the home is worth. In some situations, lenders do allow homeowners to borrow more than 80% of the purchase price, but the lenders require mortgage insurance as part of the deal. This insurance protects the lender if it has to foreclose on a property that is worth less than the loan balance. The borrower pays the insurance premiums as part of the monthly mortgage payment.

Once the borrower's loan balance drops to a certain percentage of the home value—usually 78%—the borrower can petition the lender to drop the mortgage insurance. Assuming the borrower is successful, the mortgage payment will decrease for the remainder of the loan because it no longer includes a mortgage insurance premium.

To learn how to start paying down principal more quickly, see Be Mortgage-Free Faster.