Mortgage math can be difficult. It’s not just the numbers, either. Mortgages are often made more confusing by the wide variety of terms and jargon thrown at new borrowers that make the whole mortgage process a lot less clear than it needs to be.
APR stands for annual percentage rate and is the interest you pay on your mortgage over the course of a year, plus fees and other costs. For example, if you owe $300,000 on your mortgage and you have an APR of 3%, the total interest on your mortgage over the course of a year would be $9,000. It’s 3% of $300,000 or 0.03 times $300,000.
However, you don’t make annual mortgage payments. You make monthly mortgage payments, and that can make things a bit trickier. Let’s dig into the math just a little more.
An example of a monthly mortgage payment
Let’s start by looking at what’s going on with your monthly mortgage payment. To keep it simple, let’s stick with that $300,000 mortgage and 3% interest rate, and let’s make it a 30-year mortgage.
For the next 30 years, you’ll have a mortgage payment due each month. That payment is going to be made up of two pieces — interest and principal. The principal is a small piece of the actual amount you borrowed, whereas the interest is the money you’re paying to your lender as part of repaying what you are owed.
Each monthly payment on this mortgage would be $1,264. For your first payment, you’d pay $514 toward your principal and $750 in interest.
How is that calculated? Your annual interest rate is 3%, but you’re only paying for one month of it — your monthly interest rate. If you take the 3% annual interest rate and divide that by 12, that gives you a 0.25% monthly interest rate. $300,000 times 0.25% totals up to $750, and that’s the interest portion of your payment. The rest goes toward the principal.
[Read: How to Calculate Your Mortgage]
This is where things get interesting. When you make that first payment, $514 goes toward your principal, so now you only owe $299,486.
The next month, the portion of your $1,264 payment that goes toward interest is now $299,486 times 0.25%, or $748.72. Yep, less than the month before. That means more of your payment is going toward the principal — $1,264 minus $748.72, or $515.28. This is called an amortization schedule.
This happens month after month, as long as you make the payment on time. You make the same payment, but every month a larger portion goes toward paying off what you owe, and less goes toward the interest.
If you pay more each month, that extra goes to the principal, meaning that you can pay your mortgage off even faster.
A lower APR means a lower monthly payment
The APR on your mortgage is critical because the lower it is, the lower your monthly payment is.
As noted, a 30-year $300,000 mortgage with a 3% APR gives you a monthly payment of $1,264. However, if you manage to lower that APR to 2.75%, your monthly payment drops to $1,224. That’s $40 more in your pocket each month for the next 30 years. You could use that $40 for an extra monthly payment if you wanted and pay your mortgage off years earlier.
A 0.25% shift in your APR might not seem like a big deal, but the bigger your mortgage is, the more important it becomes. It’s also worth considering that it will reduce your mortgage bill each month for the entire length of the mortgage, which can end up making a significant difference.
Don’t worry about the APY on your mortgage
Many lenders will also tell you the APY — the annual percentage yield — on your mortgage. You don’t really need to worry about this number since the APY is just a way for the lender to express how much in interest its earned over the last year. It is usually slightly higher than the APR.
However, if you’re interested, it works like this: you take that $300,000 30-year mortgage with a 3% interest rate we talked about earlier. At the end of the first year, you’d still owe $293,746.49 on your mortgage, and you would have paid $8,914.49 in interest over the first year. Your APY is the amount of interest you paid over the last year divided by how much you still owe on your mortgage. Here, it’s 3.03%.
It’s not essential to fully understand your APY. It’s just a different — and usually unclear — way of expressing your mortgage interest rate. To simplify things, stick to APR.
You can buy a lower APR upfront through mortgage points
This is where mortgage points become important. Some lenders will allow you to buy mortgage points when you take out your mortgage.
A point costs 1% of the total cost of your mortgage — in our ongoing example, a point would cost $3,000. Buying a point results in some reduction in the interest rate on your loan.
For example, your lender might agree to give you a 3% mortgage, but you can lower it to a 2.75% mortgage by buying three points. That means you pay $9,000 upfront and you get a 2.75% 30-year mortgage instead of a 3% 30-year mortgage. This is an example, and not necessarily any sort of guarantee as to what kind of offer your lender might make you.
Does it pay off? Here, that $9,000 upfront reduces your mortgage payments each month by $40 for the 30 years of the loan. That adds up to $14,400. However, if you make extra payments along the way, you won’t end up saving quite that much. It may not be a good deal to pay $9,000 to save $14,400 spread over the course of 30 years. But if you could get that rate reduction for two points or even one point? That’s a much better deal. Paying $3,000 for one point to save $14,400 over the course of the mortgage is well worth it.
A lower APR is not the only way to have a lower monthly payment
It’s worth noting that APR is not the only way to keep your monthly payment low. You can also reduce your monthly payment by reducing the total amount you borrow. Below, are some examples of things you can do to decrease your monthly mortgage payment.
- Buy a smaller home: A smaller house usually comes with a smaller sticker price, which keeps money in your pocket.
- Buy a fixer-upper: Another approach is to buy a home that needs upgrades and minor repairs, particularly ones you feel confident in handling yourself.
- Look at a cheaper living area: Consider living in a city with a lower cost of living or a suburban area with lower property values. This will allow you to have the house you desire at a lower price.
- Save for a down payment: Having a down payment reduces the amount you need to borrow. A 20% down payment also helps you avoid private mortgage insurance, an additional cost to be avoided if you can.
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