How does mortgage interest work?

How does interest affect mortgage payments?

Your mortgage interest rate has a major impact on the overall cost of your loan. A higher interest rate, even by just a few percentage points, can add thousands of dollars to your mortgage total over time.

While your interest rate may stay the same throughout your loan term, the exact amount of interest you pay each month will change. This is because of a concept called amortization, which is the process of repaying your loan in regular installments that cover both interest and principal.

Your amortization schedule details how each monthly payment is split. Early on in your mortgage, more of your payment will go toward interest because it’s calculated on a larger loan balance. As you pay down your principal and your loan amortizes, the amount of interest charged will decrease and you’ll pay off more principal each month. Your lender will be able to provide you with your mortgage’s specific amortization schedule and how it will impact your monthly payments.

Let’s consider an example. Say you sign on for a 30-year mortgage for $375,000 at a fixed rate of 4.75 percent. Here’s an estimate of how your amortization schedule would impact your payment structure over time.

Notice how the total payment stays the same each month, but the amounts going toward principal and interest shift over time. Each month, you’ll pay a little more toward the principal and a little less toward the interest.

How do mortgage interest rates work?

Now that you understand the basics of a mortgage interest rate, let’s get into the details of these rates and how they’re calculated.

Recall that your mortgage interest is calculated as a percentage of your principal, which is the total remaining balance on your loan. Each month, your mortgage payment will include a chunk toward your principal (this is how you build equity), along with interest charged by your lender.

Types of mortgage interest rates

Your exact mortgage interest rate will work differently depending on your mortgage type. Typically, there are two main types of mortgages: fixed-rate and adjustable-rate.

Fixed-rate mortgages have an interest rate that will not change for the full term of your loan. If you sign on at 4%, it will stay 4% until you pay off your loan or decide to refinance. This type of mortgage can help make budgeting easier by ensuring predictable monthly payments.

Adjustable-rate mortgages (ARMs) have an interest rate that will remain locked in for a set period of time and then switch over to a variable rate—meaning your interest rate will change periodically. Rate increases or decreases are determined by the Secured Overnight Financing Rate (SOFR), a market-based benchmark set by the Federal Reserve. This type of mortgage lets you take advantage of rate decreases and often starts with a lower rate than a fixed-rate mortgage might offer.

In contrast to standard, fully indexed adjustable-rate mortgages, some lenders offer interest-only adjustable-rate mortgages. These allow you to make payments only on your interest for a specific period of time. When that period is up, you start making regular principal and interest payments. These mortgages can offer homebuyers lower payments initially but can cost more than a traditional loan in the long run.

Annual percentage rates

If you’re exploring mortgage options, you might have run into the term “annual percentage rate.” But what is it and how is it different from your mortgage rate?

The annual percentage rate (APR) includes your mortgage interest rate plus other related charges, such as mortgage points, broker fees, and various closing costs. So, your annual percentage rate is usually higher than your mortgage interest rate alone. Be sure to talk to your lender to make sure you understand both.

The length of your mortgage term

One more thing to consider is your mortgage term and how it will impact your interest rate. In general, a longer mortgage term often comes with a higher rate. For example, you may get quoted for a lower interest rate with a 15-year mortgage vs. a 30-year mortgage, even if you’re borrowing the same amount.

While a shorter term could land you a lower rate, your monthly payments might be higher than they would be with a longer-term mortgage. For instance, if you have a $375,000 mortgage at a fixed rate of 4.75 percent, your monthly payment would be $2,917 with a 15-year mortgage vs. $1,956 with a 30-year mortgage.

While lower payments are great, keep in mind that you may end up paying more interest in the long run with a longer mortgage term. This is because you’ll be making interest payments over a larger period of time. In the above example, homebuyers with a 15-year term end up paying around $150,037 in interest, compared to about $329,224 in total interest for those with a 30-year term.

Factors affecting your mortgage rate

A mortgage interest rate isn’t one-size-fits-all. Every home buyer is going to get quoted a different rate, because lenders use a wide variety of factors to determine the specific rate for each individual.

Here are a few of the key considerations that will influence your mortgage interest rate:

• The current market rates, which are influenced by U.S. monetary policies and indices. This is especially relevant if you’re choosing an adjustable-rate mortgage, since your rate will continue to change over time.
• Your mortgage type, such as whether you’re opting for a fixed-rate or adjustable-rate mortgage. An adjustable-rate mortgage often begins with a lower fixed rate before transitioning to a variable rate.
• The loan amount, or how much you’ll be borrowing from your lender. The more you borrow, the more risk your lender is taking on – which can mean a higher interest rate.
• Your repayment term, also known as your amortization or the life of your loan. The longer your loan term, the higher your interest rate will likely be.
• Your creditworthiness, including your personal credit score. Lenders will check your credit history and score to help them predict whether you’ll be a reliable borrower and make your mortgage payments on time.

Along with different rates for fixed- and adjustable-rate mortgages, lenders will also usually offer different rates for jumbo mortgages (loans greater than $806,500). That’s because they’re taking on a higher amount of risk by lending you a larger amount of money, so the borrowing cost is higher than a conventional mortgage.

How to secure a better mortgage interest rate

When it comes to getting a mortgage, there are ways for homebuyers to boost their chances of securing a better rate. Here are some smart strategies that can help.

Improve your credit score

Your creditworthiness is a crucial factor when it comes to getting a lower rate. A good or better credit score (670+) shows potential lenders that you’re responsible with your finances, which means they’re taking on less risk when lending you money.

Lenders will typically look at your credit score along with a variety of related factors, including your:

• Credit report and credit history
• Total existing debt
• Savings and assets
• Current income

If you want to lock in a lower interest rate, improving your credit score can be a major help. You can bump up your score by making smart financial decisions like paying your bills on time, keeping your spending under control, and reducing the balances on your credit cards. The best time to start improving your credit is well before you apply for a mortgage, so there’s enough time for your actions to actually impact your score.

Bump up your down payment

When it comes to your interest rate, your down payment is a crucial piece of the puzzle. A larger down payment may help you secure a lower interest rate. Putting more money upfront means you’ll need a smaller loan to pay for your home, resulting in less risk for your lender.

A bigger down payment also helps reduce the total amount of interest you’ll pay over the life of your loan. Since interest is calculated based on your loan balance, or principal, a smaller loan amount means lower monthly interest payments.

Compare your options

Savvy buyers know that it’s important to comparison shop when you’re making a major purchase—and getting a mortgage is no exception. You’ll want to compare rates, costs, and fees across several different lenders before taking the plunge. Plus, some lenders have different offers and promotions available, so shopping around can pay off.

It’s even possible to get pre-approved by multiple lenders, which will give you a clearer idea of the rates you qualify for. That way, you can ensure you’ve done your homework and make an informed financial decision.

Take advantage of mortgage points

Another way to lower your interest rate is through something called “points” (also known as mortgage points or discount points). These points allow you to negotiate a lower interest rate with your lender by paying for a portion of your interest upfront.

Before closing, you may get the opportunity to buy points for a set percentage of your mortgage amount. In exchange, your lender will lower your interest rate by a certain amount for each point purchased. The exact cost of each point can vary, so make sure to chat with your lender before you get to closing day. Note that not all lenders offer mortgage point purchases.

Managing your mortgage rate

Ideally, you want to make sure you can handle your monthly interest payments before signing on the dotted line. But once you’re locked into your mortgage, there are still ways to help manage your interest rate and potentially make your payments easier to handle.

Many homeowners wonder, “Does paying extra to my principal lower my interest?” While it won’t change your actual rate, paying more money toward your loan balance can lead to smaller interest payments. This is because your regular interest payment is calculated as a percentage of your principal—so the lower the principal, the less interest you pay each month. However, keep in mind that not every lender permits this, as some may be unwilling or unable to recalculate your monthly interest.

Another option for homeowners looking to reduce their interest payments is refinancing. When you refinance your mortgage, you’re basically replacing your old mortgage with a new one. This can allow you to take advantage of times when interest rates are low. Refinancing can also give you the opportunity to switch mortgage types (like from adjustable-rate to fixed-rate), get rid of private mortgage insurance if you’ve built enough equity, or switch to a new lender with better rates.

The bottom line

Mortgage interest rates may seem straightforward, but there are plenty of details and lenders to consider. That’s why it’s important to have a knowledgeable mortgage specialist who can walk you through the ins and outs of mortgage rates and how they’ll affect your individual situation.

If you’re ready to get started, see what you can afford with our Mortgage Interest Payment Calculator or get in touch with a mortgage specialist today.