The majority of loans include interest as payment to the lender for their services, and mortgages are no exception. Unless you can pay entirely with cash, mortgage interest is an expense you should expect with homeownership. But how exactly does your lender decide how much you should pay each month in interest?
To understand that, you’ll first need to know how compound interest works. Many mortgages use the compound interest formula to determine the way in which interest will generate on the principal balance during your repayment period. Let’s break down what exactly compound interest is and how it plays into your monthly bill.
What Is Compound Interest?
Compound interest is added to the principal amount of a deposit or a loan. It can also be defined as interest on interest. Compound interest allows money to grow exponentially compared to simple interest. With compound interest, the interest is added back into the principal balance and continues to grow.
For example, let’s say you have a $10,000 deposit that earns 5% interest. If the 5% interest compounds annually, you’ll have $10,500 by the end of the year. Then, after the second year, you would have $11,025. If you were to receive simple interest, you would only have $11,000 after 2 years.
The same concept applies to compound interest on a debt you owe, such as a mortgage. Unpaid interest goes back into your principal balance each time the interest is scheduled to compound, which can add up to a substantial amount of total interest paid over the course of a 15- or 30-year mortgage. Instead of earning the interest you make on your interest, you pay it.
How Is Mortgage Interest Compounded?
If your mortgage includes compounding interest, there are several factors that will determine how quickly your interest accumulates and how much you’ll end up paying.
Regardless of whether you’re reaping the benefits of compounding investments or paying it on your mortgage, every type of compound interest uses what’s known as the compounding frequency. Your frequency of compounding will essentially determine the rate in which your interest accrues over a set period.
A mortgage that compounds monthly, for example, will add the current outstanding interest back into your principal once every month. Some loans may have a much higher compounding frequency, accruing interest weekly or daily. The more frequently your mortgage interest compounds, the more opportunities your interest will have to grow.
In an effort to reduce the total amount of interest they pay, many borrowers make plans to pay off their mortgages well ahead of schedule. One strategy is the biweekly payment plan, which adds an additional month’s worth of mortgage payments each year. Because this additional month’s payment goes completely to principal, paying more than the minimum required on your bill helps prevent interest from accumulating and compounding over time. This strategy can help you quickly make substantial reductions to your current principal.
Calculating Compound Interest On A Mortgage
To understand how to calculate compound interest on a mortgage, let’s first look at the compound interest formula:
A = P(1 + r/n)^(nt)
- A = the total amount (including both principal and compounded interest)
- P = the original principal balance lended or borrowed
- r = the interest rate
- n = the compounding frequency, or the number of times the interest compounds over a set period of time
- t = the number of compounding time periods
If you’re familiar with the simple interest equation, calculating compound interest uses more variables and is a more involved computation. It’s for this very reason that many borrowers find compounding interest confusing when it comes to fully grasping the exact amount they have to pay.
An easier approach to calculating how much you’ll pay for your mortgage is to use a mortgage amortization calculator, which breaks down how your principal and interest are paid over the course of your loan. If you’re unfamiliar with the term, a mortgage amortization outlines a loan’s repayment plan. Generally speaking, as your loan balance gets lower, you’ll put more toward principal and less toward interest payments, and an amortization schedule does a great job of illustrating this breakdown.
Understanding Annual Percentage Yield
You’ve likely heard of APR, or annual percentage rate, which totals your interest rate and loan fees for a better picture of how much you’ll end up paying. APR is often a better indicator than interest rate alone when you’re trying to determine just how much a loan will cost you. Since APR is only used for simple interest loans, however, you’ll need to rely on a different measurement that accounts for compound interest. That’s where annual percentage yield (APY) comes into play.
You can use APY to determine the amount you earn or pay on a compounding annual interest rate. When you’re investing, a high APY means you’ll be building more wealth on that interest over time. Alternatively, you’ll want a low APY on money you’ve borrowed to keep interest growth and monthly payments at a minimum.
How To Determine What Type Of Interest Your Home Loan Charges
Unsure of how the interest on your mortgage is currently calculated? Your lender should have the answer.
Thanks to the Truth in Lending Act (TILA) of 1968, lenders are legally obligated to disclose the terms of your mortgage with you, which includes the total amount of interest and fees that are due over the course of the loan. Designed to protect borrowers from predatory lending practices, TILA discloses the factors that go into interest calculations, which can help you make the best decision for your finances before you sign on any dotted lines.
How Compound Interest Adds Value
If you’ve ever paid compounding interest on a loan, you might wonder if it’s possible to reap the benefits of compound interest instead. Outside of student loans, car payments, mortgages and other borrowed money, compounding interest becomes a formidable tool for growing your wealth, especially over a long period of time. And compared to simple interest, compound interest contributions can generate wealth exponentially and yield far greater returns for the same purchase amount. As an example, certificates of deposit, certain savings accounts and bonds are all investments that are well-regarded as compounding opportunities.
Helping your money grow isn’t the only value that compound interest adds. There are several other reasons why compound interest is powerful. Here are a few other reasons why compound interest can be valuable to your investment strategy.
Compound Interest Utilizes The Power Of Momentum
Imagine an avalanche. It starts with a small amount of snow and then gradually builds as it soars down the mountain. After it builds up enough momentum, the snow mass becomes gigantic and can take out anything in its path.
Compound interest acts in the same manner. It takes some time and effort to build up at first and then it begins to rapidly grow. Once your wealth is built, it begins to attract more wealth.
Compound Interest Can Help The Wealthy And The Poor
When it comes to compound interest, your financial situation doesn’t matter. It crushes the myth that the average person doesn’t have enough to invest in the stock market. Anyone with even a small amount of money can invest and earn compound interest.
For example, let’s say you make $40,000 a year and decide to invest 10% of your income annually. If you’re consistent, you will have $798,540.45 after 40 years, assuming 7% interest. Keep in mind, this example is just one of countless scenarios. Depending on investments, many people may get more than 7% over decades, and some people may get less.
Compound Interest Rewards Discipline
Life happens, and you may be tempted to use your savings toward other financial goals. Maybe you want to use your savings to pay for your next family vacation or a new luxury car. However, compound interest rewards investors for staying consistent and being disciplined.
So, when you think about pulling your money out of your savings, maybe think again. Compound interest works best when you consistently contribute to your accounts over time.
Compound Interest Teaches Patience
The media and financial experts will always have opinions of the happenings within the market. These opinions cause investors to make irrational investing decisions or try to time the market. The market is massive and has many factors that make it almost impossible to do so. That’s why consistently investing over time may be one of the best strategies for creating long-term wealth.
Creating wealth doesn’t usually happen overnight. But by staying the course, you will be able to reap the benefits in the future.
Compound Interest Separates The Financially Secure From The Broke
If you’ve ever had high-interest credit card debt, you may have noticed the balance doesn’t decrease much once you made a payment. Often, if your balance is large enough, and your payments are the minimum, your credit card balance may have even increased.
High-interest debt uses compound interest against you. If you’re making minimum payments, it can be challenging to repay your debt. You’re essentially fighting an uphill battle.
Instead of fighting against wealth, create positive financial habits to help you achieve wealth. If you continue to have poor financial habits, you will continue to fight interest and may never become wealthy.
That’s why you should use compound interest to your advantage and create an abundant financial future.
Why Is Compound Interest Important To Understand?
Compound interest is an important financial concept to understand on both sides of the coin. Knowing the impact of compound interest on your mortgage or other types of loans is critical to make the most of your money and develop a solid repayment strategy.
Plus, the sooner you pay off your compound interest loans, the more opportunities you’ll have to leverage compound interest in your investments.
If one of your financial goals is to save for retirement, utilizing compound interest may be the best way to achieve it. If you decide to stash your money under your mattress, you may not be able to reach this goal as fast or even at all.
Whether you open a high-yield savings account or an investment account, you should start contributing to an investment in your future. The earlier you start, the more time you have to grow your money.
Keep in mind, compound interest isn’t just for millionaires. Any investor has the opportunity to earn interest on interest.
The Bottom Line
Compound interest operates the same whether you’re earning it on an investment or paying it on a mortgage. The only factor that changes is whether or not that accrued interest is money you’ll pay or earn.
By learning how to make the most of your mortgage interest, you can develop a payment plan that helps you save money on interest. Leveraging those same skills on your savings and investments accounts allows you to make money with your money. In both of these circumstances, however, taking advantage of compound interest in the future starts with the financial moves you make today.
If you’re interested in learning more about the role interest plays in your personal finances, visit the Quicken Loans®️ Learning Center.
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