How Do Mortgage Interest Rates Work?

Even if you've found your ideal home, your dreams may be dashed if you can't afford it. Mortgage interest rates significantly affect your long-term costs when you buy a house. You can better evaluate the affordability of a home loan when you understand how do mortgage interest rates work.

What Is a Mortgage Interest Rate? 

Mortgage interest is the price you pay when borrowing money from a lender. Mortgage interest rates vary based on your financial situation and economic conditions. 

How Is Interest Calculated on a Mortgage?

Several factors make up your monthly mortgage payment.

Principal

Your mortgage principal is the money you borrowed to buy your home. A portion of your monthly mortgage payment reduces the total principal that you owe. 

Interest

Lenders charge interest as a percentage of your unpaid debt. Your mortgage payment includes both interest and principal. As your unpaid debt decreases, so does the amount you pay for interest. 

Taxes

Many lenders require you to make payments toward your annual real estate taxes. Lenders typically add 1/12 of your property’s estimated taxes to your monthly mortgage payment.

Lenders place these funds in an escrow account. Your lender uses these escrow funds to pay your real estate taxes when they become due. 

Term/Length

Your monthly mortgage payment is affected by the length of your loan. The more time you have to pay off your mortgage, the lower your payments will be. So, if you take out a 30-year mortgage, your monthly payments will be less than if you entered a 15-year mortgage. 

Mortgage Insurance

A lender may require you to get mortgage insurance when you lack equity. Mortgage insurance protects the lender if you don't pay back what you owe.

Mortgage insurance may be necessary if you put down less than 20% or have a specific type of loan that requires it. These policies are an additional cost that gets added to your monthly payment. 

Amortization

Amortization is the process of paying down your mortgage principal. Since the interest you pay is based on the balance you owe, most of your monthly payment goes toward interest when you first take out a mortgage. Only a small portion goes to paying down your debt.

Over time, more of your monthly payment will be used to reduce your mortgage balance until you’ve paid it off. 

Example of How Mortgage Interest Rate Works

When you begin paying your mortgage, most of your payment goes toward interest. As you continue paying your mortgage, more monthly payments shift toward the principal. 

To illustrate how home mortgage interest rates work, consider the following example:

The home price is $300,000 with 20 percent down. 

30-year mortgage for $240,000 at a fixed rate of 6.00 percent.

The monthly payment is $1,439.

How Does Interest Work for Different Types of Mortgages?

The amount of interest you pay depends on the mortgage you take out.   

Fixed-Rate Mortgages

With a fixed-rate mortgage, your interest rate remains the same over the life of the loan. Not only will your interest rate remain the same, but your monthly payment will also stay the same. Fixed-rate mortgages offer stability and protection against rising interest rates. 

Adjustable-Rate Mortgages (ARMs)

An adjustable-rate mortgage (ARM) has an interest rate that can change over time. Many times, an ARM begins with a low introductory rate. Once you pass the introductory period, your interest rate could rise or fall. As your mortgage interest rate changes under an ARM, so does your monthly payment.

An ARM may be a good option if you sell your home or refinance in a few years. However, a steep rise in payment could stress your finances. 

Jumbo Mortgage Loans

A jumbo mortgage loan has a loan limit greater than the limit set by the Federal Housing and Finance Agency (FHFA). You'll need to meet minimum income requirements and have a strong credit score. Jumbo mortgages often come with higher interest rates. 

Interest-Only Mortgages

With an interest-only mortgage, you make payments toward the interest owed only. Since your monthly payment doesn’t include principal, your payments are typically lower than a traditional mortgage.

How Does Mortgage Interest Deduction Work?

If you itemize when filing your taxes, you could deduct part or all of what you pay in mortgage interest. Your home must secure your debt for its interest to qualify for the deduction. 

If you bought your home after Dec. 16, 2017, you could deduct interest paid on the first $750,000 of your mortgage if you are a single or joint filer. You may deduct interest on the first $375,000 of your mortgage if married filing separately.

Remember that you can't deduct mortgage interest if you claim the standard deduction on your tax return. 

How to Get the Best Mortgage Interest Rate

Seeking out the best mortgage interest rate possible can save you money. Here are some ways to boost your chances of getting the best mortgage rate:

• Stable employment: Lenders look at your employment history when evaluating your ability to repay your debt. Lenders usually look favorably on borrowers with two or more years of consistent employment. However, if you have gaps in employment or don’t have consistent income because you are self-employed, the lender might charge you a higher rate.
• Improve your credit score: A strong credit score increases your chances of getting a lower mortgage interest rate. You can boost your score by consistently paying what you owe on time and lowering your credit utilization ratio.
• Shop around: Comparing rates from multiple lenders could help you get a lower mortgage interest rate.
• Put more money down: The larger your down payment, the less money you borrow. Since lenders take on less risk when you put more money down, you could get a lower mortgage interest rate.
• Points: You could pay an additional fee or points to lower your rate. 

Find the Best Mortgage Companies: Benzinga’s Top Providers

Knowing how much you can borrow is critical when buying a house. We compiled a list of the best mortgage companies based on approval time, customer support and specialty loan products. 

Choose the Best Mortgage for your Financial Situation

Buying a home is one of the most significant financial decisions. Yet, equally important is the mortgage you take out. Understanding how mortgage interest rates work can help you get the house of your dreams. 

Frequently Asked Questions