Understanding how mortgage interest is calculated is the single most important piece of knowledge for any homebuyer. When you sign a 30-year mortgage, you aren’t just borrowing the purchase price of the home—you are agreeing to pay a massive premium over time.
The Concept of Amortization
Mortgages are amortized loans. This means your monthly payment remains exactly the same every month for the entire life of the loan (assuming a fixed-rate mortgage). However, what changes is how that payment is divided between principal (the actual amount you borrowed) and interest (the bank’s profit).
In the first few years of a 30-year mortgage, the vast majority of your payment goes toward interest. As the years pass, the balance shifts, and more of your payment goes toward the principal.
The Monthly Interest Formula
Banks don’t calculate your total interest for 30 years and divide it by 360 months. Instead, they calculate your interest every single month based on your remaining outstanding balance.
Here is the formula:
Monthly Interest = Outstanding Balance × (Annual Interest Rate / 12)
An Example Calculation
Let’s say you have a $300,000 mortgage at a 6.0% annual interest rate.
- Your annual rate is 6.0% (0.06).
- Your monthly rate is 0.06 / 12 = 0.005.
- For Month 1, your interest charge is $300,000 × 0.005 = $1,500.
If your total fixed monthly payment is $1,798, then for Month 1:
- $1,500 goes to the bank as interest.
- Only $298 goes toward paying down your principal.
For Month 2, your new balance is $299,702. The interest calculation runs again on this slightly smaller number, resulting in a slightly smaller interest charge.
How to Beat the Math
Because interest is calculated on the remaining balance every single month, any extra payment you make toward the principal immediately permanently reduces all future interest calculations.
Making just one extra mortgage payment per year can shave 4 to 5 years off a 30-year mortgage and save you tens of thousands of dollars in interest.
To see exactly how much you can save on your specific loan, use our Prepayment Simulator to visualize the impact of extra payments.