Understanding Mortgage Principal Reduction: A Comprehensive Guide

The principal reduction of a mortgage loan doesn't follow the monthly payments — only part of each payment goes toward the principal, while the rest goes toward the interest. With fixed monthly payments, the ratio between the principal and interest amount changes each month. As the balance decreases, the amount going toward the interest decreases, and the amount going toward the principal increases.

Interest & Principal

Interest is money charged for an outstanding loan. With fixed monthly payments, the monthly interest rate is used for the monthly charge. The monthly interest rate is 1/12 of the annual rate. You always pay the previous month's balance times the monthly rate. Any amount above the interest charge goes toward the principal. The principal reduces your loan balance. The reduced loan balance carries less interest for the next month's payment. The difference in interest is added to the principal.

Annual Effective Rate

You can't multiply the beginning loan balance by the annual interest rate for the annual interest amount unless you have an interest-only loan. Otherwise, the declining monthly balance affects the overall annual interest. You can multiply the monthly interest rate by the previous month's balance for the monthly interest amount; then add each 12 monthly amounts for each year's annual amount. You then divide the annual amount by the beginning balance for each year's effective yearly rate. You can also divide the annual amount by the original balance for each year's beginning-balance effective rate. The total interest amount for the whole loan divided by the loan amount gives you the total effective rate.

Average Balance

The annual effective rate is lower than the annual interest rate because your balance changes midstream. The regular annual rate is accurate, but it doesn't have a consistent amount to apply to. You can average the loan balances for each year and multiply that by the annual interest rate for the annual interest amount. If you average all of the loan balances and multiply that by the annual rate times the number of years in the loan, you get the total interest amount.

Loan Reduction

Once you know how much interest you have to pay, you can figure out the principal reduction amount. Subtract the monthly interest from the monthly payment for the monthly principal reduction. Alternatively, subtract the annual interest from the annual payment for the annual principal reduction. Subtract the reduction from the previous balance for the new balance.