Planning a mortgage loan to buy your next home? Confused about how principal, interest and equity fit into the picture? They are related, yet they change monthly.

Say you purchase a home for $160,000, with $35,000 down. You borrow $125,000 at 7.25% for thirty years. Your "equity" the day of the purchase would be $35,000, the difference between the value of the home and what you owe. The "principal" of your loan would be the $125,000 borrowed. Your monthly payments for "principal" and "interest" would be $852.72.

Of your first payment, the interest portion will be $755.21, while only $97.51 will apply to the principal (the amount you borrowed). Interest is the amount you owe ($125,000) multiplied by your annual interest rate (%7.25) then divided by 12 (the number of payments per year). As the principal declines slightly each month, so will the interest paid.

After five years, the interest portion of your monthly payment decreases to $713.60, while the principal would increase to $139.12. The remaining principal balance is reduced to $117,973. Assuming the home appreciated 3% per year in value, it would be worth $185,483 at the end of five years, and equity would have increased to $67,510.

While the math may be a bit confusing, the reality is not. With each payment, valuable equity in your home increases.