How Does Mortgage Interest Work? Simple Explanation with Examples

Mortgage interest is calculated monthly by multiplying your remaining loan balance by your annual interest rate divided by 12. On a $300,000 loan at 6.5%, your first month’s interest is $1,625 ($300,000 × 0.065 ÷ 12). As you pay down the principal, less of each payment goes to interest and more goes to principal—this is called amortization.

How Mortgage Interest Is Calculated

Your monthly interest payment depends on your current loan balance and interest rate.

The Basic Formula

Monthly interest = Loan balance × (Annual rate ÷ 12)

Example:

Loan balance: $350,000
Annual rate: 6.5%
Monthly rate: 0.065 ÷ 12 = 0.00542
First month interest: $350,000 × 0.00542 = $1,896

Why Early Payments Are Mostly Interest

In a 30-year mortgage, early payments are interest-heavy because:

Your balance is highest at the beginning
Interest is calculated on that large balance
The fixed payment minus interest leaves little for principal

First payment breakdown ($350,000 at 6.5%):

Total payment: $2,212
Interest portion: $1,896 (86%)
Principal portion: $316 (14%)

Payment after 15 years:

Total payment: $2,212 (same)
Interest portion: $1,032 (47%)
Principal portion: $1,180 (53%)

Payment in year 29:

Total payment: $2,212 (same)
Interest portion: $168 (8%)
Principal portion: $2,044 (92%)

Understanding Amortization

Amortization is the process of paying off a loan through scheduled payments that cover both principal and interest.

How Amortization Works

Each payment is split between:

Interest: Payment to the lender for borrowing money
Principal: Payment that reduces your loan balance

With fixed-rate loans, your total payment stays the same, but the split changes over time. Early on, most goes to interest. Later, most goes to principal.

Amortization Schedule Example

First 5 years of a $300,000 loan at 6.5%, 30 years:

Year	Payment	Interest	Principal	Balance
1	$22,764	$19,349	$3,415	$296,585
2	$22,764	$19,116	$3,648	$292,937
3	$22,764	$18,864	$3,900	$289,037
4	$22,764	$18,592	$4,172	$284,865
5	$22,764	$18,298	$4,466	$280,399

After 5 years, you’ve paid $113,820 total but only reduced the balance by $19,601. The other $94,219 went to interest.

Total Interest Over Life of Loan

$300,000 loan at different rates (30 years):

Rate	Monthly Payment	Total Interest	Total Paid
5.0%	$1,610	$279,767	$579,767
5.5%	$1,703	$313,212	$613,212
6.0%	$1,799	$347,515	$647,515
6.5%	$1,896	$382,633	$682,633
7.0%	$1,996	$418,527	$718,527
7.5%	$2,098	$455,157	$755,157

A 1% rate difference on $300,000 means about $68,000 more or less in total interest.

Fixed vs. Adjustable Interest Rates

The two main rate types work very differently.

Fixed-Rate Mortgages

How it works: Your rate never changes for the entire loan term.

Monthly payment: Stays exactly the same for 15 or 30 years

Best for:

Buyers who want payment stability
Those planning to stay long-term
When rates are relatively low
Risk-averse borrowers

Example: Marcus locks in 6.5% on a 30-year loan. Whether rates rise to 9% or fall to 4%, his rate stays 6.5% forever.

Adjustable-Rate Mortgages (ARMs)

How it works: Rate is fixed initially, then adjusts periodically based on a market index.

Common ARM types:

5/1 ARM: Fixed for 5 years, adjusts annually after
7/1 ARM: Fixed for 7 years, adjusts annually after
10/1 ARM: Fixed for 10 years, adjusts annually after

Rate components:

Index: Market rate the ARM follows (SOFR, Treasury, etc.)
Margin: Lender’s markup (typically 2-3%)
Caps: Limits on how much rate can change

ARM cap structure (example 2/2/5):

First adjustment cap: 2% maximum change
Subsequent cap: 2% per adjustment
Lifetime cap: 5% total change from start rate

Fixed vs. ARM Comparison

Starting rate: 6.5% fixed vs. 5.5% ARM

Scenario	Fixed Payment	ARM Payment	Winner
Rates unchanged	$2,212	$1,939	ARM
Rates rise 2%	$2,212	$2,329	Fixed
Rates fall 2%	$2,212	$1,568	ARM
Sell in 5 years	$132,720 paid	$116,340 paid	ARM

Choose ARM if:

You’ll sell or refinance within the fixed period
You can handle potential payment increases
Current ARM rates are significantly lower

Choose fixed if:

You’re staying long-term
You want payment predictability
Rates are historically reasonable

How to Pay Less Interest

Several strategies reduce total interest paid.

Make Extra Principal Payments

Extra payments reduce your balance faster, meaning less interest accrues.

$300,000 at 6.5%, adding $200/month extra:

Standard payoff: 30 years, $382,633 interest
With extra payments: 24.5 years, $298,214 interest
Savings: $84,419 and 5.5 years

Choose a Shorter Loan Term

15-year loans have lower rates and pay off faster.

$300,000 comparison:

Term	Rate	Payment	Total Interest
30 years	6.5%	$1,896	$382,633
15 years	5.75%	$2,492	$148,560
Difference		+$596/mo	-$234,073

The 15-year payment is $596 higher, but you save $234,073 in interest.

Refinance to a Lower Rate

If rates drop significantly, refinancing can reduce your interest cost.

When refinancing makes sense:

Rate drops 0.5% or more
You’ll stay long enough to recoup closing costs
Your credit has improved significantly

Example: Jennifer refinances from 7.5% to 6.5% on $280,000 balance. Monthly savings: $186. With $4,500 closing costs, break-even is 24 months.

Make Biweekly Payments

Paying half your monthly payment every two weeks equals 13 full payments per year instead of 12.

$300,000 at 6.5%:

Standard: 30 years, $382,633 interest
Biweekly: 25 years 4 months, $314,000 interest
Savings: $68,633 and 4.7 years

Put More Down Initially

A larger down payment means a smaller loan and less interest.

$400,000 home at 6.5%:

Down Payment	Loan Amount	Total Interest (30 yr)
5% ($20,000)	$380,000	$484,674
10% ($40,000)	$360,000	$459,165
20% ($80,000)	$320,000	$408,148

Putting 20% down instead of 5% saves $76,526 in interest—plus you avoid PMI.

Interest Rate vs. APR

These related numbers measure different things.

Interest Rate

The base cost of borrowing, expressed as a percentage. Used to calculate your monthly payment.

Annual Percentage Rate (APR)

The total cost of borrowing including rate plus fees, spread over the loan term. Always higher than the interest rate.

APR includes:

Interest rate
Origination fees
Discount points
Mortgage insurance
Some closing costs

Which to Compare?

Use interest rate for: Calculating your actual monthly payment

Use APR for: Comparing total cost between lenders with different fee structures

Example:

Lender A: 6.5% rate, 6.7% APR (low fees)
Lender B: 6.375% rate, 6.8% APR (high fees)

Lender B has a lower rate but higher overall cost. If you’re keeping the loan long-term, the lower rate might win. If you’re refinancing soon, the lower fees (Lender A) might be better.

Simple vs. Compound Interest

Mortgages use simple interest, not compound interest.

Simple Interest (Mortgages)

Interest is calculated only on the principal balance. When you make a payment, the principal portion reduces the balance, and next month’s interest is calculated on that lower balance.

Compound Interest (Not Used for Mortgages)

Interest is calculated on principal plus accumulated interest. The interest earns interest. Credit cards work this way.

Why it matters: With simple interest, extra payments immediately reduce your balance and future interest. There’s no compounding working against you.

Factors That Affect Your Interest Rate

Your rate depends on both market conditions and your personal profile.

Market Factors (You Can’t Control)

Federal Reserve policy: Rate hikes push mortgage rates up
Inflation: Higher inflation means higher rates
Bond market: Mortgages track 10-year Treasury yields
Economic conditions: Recessions often lower rates

Personal Factors (You Can Control)

Factor	Impact on Rate
Credit score 760+	Best rates
Credit score 620	+1.0-1.5% higher
20%+ down payment	Best rates
5% down payment	+0.25-0.5% higher
30-year term	Standard
15-year term	0.5-0.75% lower
Owner-occupied	Standard
Investment property	+0.5-0.75% higher
Conforming loan	Standard
Jumbo loan	+0.25-0.5% higher

Frequently Asked Questions

Is mortgage interest calculated daily or monthly?

For most mortgages, interest is calculated monthly on the remaining balance. Your payment due date determines when interest accrues. Some specialty loans calculate interest daily, but this is uncommon for residential mortgages.

Why does so much of my payment go to interest?

Early in your loan, the balance is highest. Since interest is calculated on the balance, a larger balance means more interest. As you pay down principal, the interest portion shrinks and principal portion grows.

Does paying principal reduce interest?

Yes. When you pay extra toward principal, you reduce the balance that interest is calculated on. Lower balance = less interest next month = faster payoff. Every extra dollar toward principal saves you interest.

How much interest will I pay over 30 years?

It depends on your loan amount and rate. A rough estimate: you’ll pay about the same amount in interest as you borrowed. A $300,000 loan at 6.5% costs about $383,000 in interest over 30 years—more than the original loan amount.

Is it better to pay down mortgage or invest?

If your mortgage rate exceeds expected investment returns (after taxes), pay down the mortgage. If your rate is low (under 5%) and you’re comfortable with investment risk, investing may build more wealth. Many people do both for diversification.

When does interest start on a mortgage?

Interest begins accruing the day your loan funds. Your first payment typically includes interest from the funding date through the end of that month (prepaid interest paid at closing) plus the following month.