The interest paid on a mortgage doesn't really compound because the current interest due is paid with each monthly mortgage payment. Since you are paying off a long-term debt, what has the effect of compounding is the principal reduction amounts on the loan. With each mortgage payment, you can track how much interest is paid on the loan and how much of the payment goes to pay down the loan balance.
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Things you need
- Current mortgage statement
Look up your current mortgage balance from your mortgage statement, along with the annual interest rate and monthly loan payment. The loan payment amount is the principal and interest payment and does not include the amount of your payment that goes into the escrow account for taxes and insurance.
Calculate the monthly interest rate on the loan by dividing the annual rate by 12. Mortgage interest is calculated monthly in conjunction with the monthly payment. For example, if your annual rate is 6 per cent, the monthly rate is 0.5 per cent.
Multiply the monthly interest rate times your current loan balance. The result is the interest paid on the next payment. If the loan has a current balance of £130,000 and the monthly interest is 0.5 per cent, the interest for the month is £650.
Subtract the interest payment from the loan payment to determine the amount of principal reduction. If the payment on the example loan is £812, subtracting the £650 of interest leaves £162 in principal reduction. When the payment has been made, the new loan balance will be £129,837.
Calculate the interest and principal for the next monthly payment using the same method. With a new loan balance of £129,837, multiplying by 0.5 per cent gives an interest charge of £649.1. The principal reduction for the next payment will increase to £163.3, and the new loan balance will be £129,674.1.
Tips and warnings
- On a fixed rate mortgage, each month the interest charge will decrease and the principal reduction amount will increase, compounding the effect of additional payments on the principal balance.
- Mortgage interest is calculated on the outstanding loan balance. The interest paid can be reduced by reducing the loan balance with extra principal payments.
- If a mortgage payment is paid late, the mortgage company does not compound the interest. Instead, the lender will add late fees to the missing payment or payments.
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