What it means
With a level payment mortgage, the payment you make in month one is the same as the payment in month 300. What changes is the split between interest and principal (the amount actually borrowed).
At the start, most of the payment is interest because the balance is large, and over time the interest portion shrinks while the principal portion grows. This design is called full amortisation, meaning the loan is paid down to zero by the end of the term.
Typical terms are 15, 20 or 30 years. A longer term lowers the monthly payment but means much more total interest, while a shorter term does the opposite.
The payment is found using a standard formula that depends on the loan amount, the interest rate per period and the number of payments. Lenders and borrowers can also use a spreadsheet function.
Because the rate is fixed, the borrower is protected if market rates rise, but cannot benefit if rates fall unless they refinance. For a business or household, the main benefit is budgeting certainty.
A fixed payment makes cash flow forecasting straightforward, and it protects against payment shock. The cost is that the fixed rate is often set slightly higher than the starting rate on a variable loan, to compensate the lender for taking the rate risk.
An alternative is a graduated payment or adjustable-rate loan, where the payment changes. Some borrowers also add extra principal payments to a level payment mortgage, which shortens the term and reduces the total interest paid without changing the required payment.
In practice
Real-world examples.
Example
A couple buys their first home with a $240,000 mortgage and chooses a level payment loan for 30 years. They like knowing that their payment will not change, even if interest rates rise sharply in later years.
Example
A small business owner buys a $500,000 commercial building with a 20-year level payment mortgage. The finance manager builds the fixed payment into the annual budget and plans the other costs of the business around it.
Example
A homeowner with a level payment mortgage receives an annual bonus and uses it to make an extra principal payment. The required monthly payment stays the same, but the loan balance falls faster and the final payoff date moves earlier.
Formula
Calculation
Payment = Loan x r / (1 - (1 + r) ^ -n), where r is the interest rate per period and n is the number of payments.
Worked example: a borrower takes a $300,000 loan at 6% a year for 30 years, with monthly payments.
Monthly rate r = 6% / 12 = 0.5% = 0.005. Number of payments n = 30 x 12 = 360.
(1.005) ^ 360 = 6.0226, so (1.005) ^ -360 = 0.16604, and 1 - 0.16604 = 0.83396.
Payment = $300,000 x 0.005 / 0.83396 = $1,500 / 0.83396 = about $1,798.65 a month.
In month one, interest is $300,000 x 0.005 = $1,500, so the principal repaid is $1,798.65 - $1,500 = $298.65. Over 360 payments, the borrower pays a total of about $1,798.65 x 360 = $647,514, of which about $347,514 is interest.Case study
Seen in the real world.
Elmwood Properties is a fictional landlord that bought a small apartment block with a $600,000 loan. Two offers were on the table: a 30-year level payment mortgage at a fixed 6% and an adjustable-rate loan starting at a lower rate.
The fixed loan had a payment of about $3,597 a month, and the adjustable loan began at about $3,200 but could rise. The finance director modelled a three-point rate rise, which would have lifted the adjustable payment well above the fixed one.
Because the rental income was fixed by long leases, she chose the level payment loan to protect margins. This is an illustrative story, but it shows how payment stability can be worth a higher starting cost.
Watch out
Common mistakes.
- Thinking the interest and principal split is constant. The total payment is level, but the interest share falls and the principal share rises every month.
- Focusing only on the monthly payment. A longer term lowers the payment but can add tens of thousands of dollars in total interest.
- Forgetting other costs. Property taxes, insurance and maintenance are separate from the mortgage payment and can change over time.
Questions
People also ask.
What does fully amortising mean?
It means the scheduled payments will pay off the whole loan by the end of the term, with no balance left over. Some loans, such as interest-only or balloon loans, are not fully amortising.
Can I pay off a level payment mortgage early?
Usually yes, and doing so saves interest. Check whether the lender charges a prepayment penalty first.
Does the payment ever change?
The principal and interest do not change on a fixed-rate loan. If the payment includes tax and insurance in an escrow account, the total amount may change.
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