How Does Mortgage Interest Work?

The dynamics of mortgage interest rates can be a little complex. However, gaining a basic understanding of some key components combined with the expertise of your loan officer will help you choose a loan that’s right for you. Let’s take a closer look at a few concepts and terms that will help you better understand how mortgage interest rates work.

Here is How Your Mortgage Is Calculated

Amortization

Mortgages are repaid with amortization. This is an established installment loan repayment schedule that includes your overall monthly payment and how much of it will go toward paying down your loan's principal balance. This schedule applies an increasing portion of your monthly payment toward the principal balance, decreasing portion toward the total interest owed over the life of the loan. You choose an amortization period when you are approved, and decide what term mortgage you want: 30-year, 15-year, etc.

The shorter the amortization period, the less you pay in interest. If you make payments according to the loan's amortization schedule, your loan will be fully paid off by the end of its set term.

If your mortgage is a fixed-rate loan, each payment will be an equal dollar amount. However, if your mortgage is an adjustable-rate loan, the payment will change periodically as the interest rate on the loan changes.

Although the amortization period has nothing to do with interest rates, the longer the amortization period, the more you pay in interest.

Mortgage Term (10 Year, 15 Year, 20 Year and 30 Year Mortgages)

The term of your loan is how long you have to repay the loan.

In general, shorter terms have lower interest rates but they also have higher monthly payments. 10–year and 15–year fixed–rate mortgage offers shorter terms. They can save you money because you are borrowing money and paying interest for a shorter amount of time. You'll also pay off the balance quicker and own your home outright much quicker.

Understandably, not everyone can afford a higher monthly payment. According to Freddie Mac, most borrowers choose a 30–year fixed–rate mortgage. In fact, the 30-year fixed-rate mortgage is chosen by nearly 90% of today's homeowners.

The mortgage term that is best for you will depend on your individual financial situation, the house you want, and what you can afford. Using a mortgage calculator will help you determine what term is right for you.

Whether you choose a term of 10-, 15-, 20, or 30-years, a fixed-rate mortgage guarantees that your monthly mortgage payment will remain the same for the entire term of the loan.  

Your choice of a loan term will affect your monthly principal and interest payment. It also impacts your interest rate and how much interest you will pay over the life of the loan.

Your Credit Score

Your credit score differs from your credit report. A credit report is an extensive record of your financial history and how you’ve handled the obligation to repay your loans. Lines of credit that you’ve opened or closed, auto loans, home loans, even civil cases such as bankruptcy and lawsuits will also appear in your report. 

Your credit score is a number that’s based upon various weighted factors in your financial history. These include payment history, amount of debt, types of credit, and length of credit history. Recent searches for credit– also known as “hard pulls”- are also factored by companies looking at your credit score when you apply for a substantial loan.

Multiple hard pulls can impact your credit score, however, when shopping around for a loan within a short time frame, most scoring models count clustered “hard pulls” within a time limit of 14-45 days as a single combined inquiry, limiting the decrease in your score.

Your credit score is used to predict how reliable you’ll be in paying your mortgage loan. Generally, borrowers with higher credit scores receive lower interest rates than consumers with lower credit scores. 

Before you begin to shop for a mortgage, check your credit reports and review them for errors. An error on your credit report can lead to a lower score so be sure to dispute any possible errors with the credit reporting company.

An accurate credit report will help maximize your credit score, thus affecting the interest rate you may be offered from a mortgage lender.

Your Down Payment

A down payment is a percentage of the home’s purchase price that is paid in full at closing, upfront. It’s important to note that the amount a home buyer is required to put down varies by loan type.

When a lender reviews your finances to determine the best financing solution for you, the down payment amount is a very big factor. The amount you put down impacts the loan type, interest rate, and other loan costs.

Determine how much money you feel comfortable putting down by assessing your finances. Depending on the loan program, the down payment requirement can range from no money down all the way up to 20%. When a borrower chooses a lower down payment, the monthly mortgage payment is higher because with less money down towards the mortgage, there’s a higher balance to pay back over the life of the loan.

When you put more money down, a lender may be able to offer a lower interest rate, resulting in a lower monthly mortgage payment. 

Types of Mortgage Rates that Affect Your Rate

Fixed Rate Mortgage

Fixed-rate mortgages are the most common loan option among borrowers. With a fixed-rate mortgage, your interest rate stays the same throughout the life of the mortgage. Although your interest rate can never go up, it also could be higher on average than an adjustable-rate mortgage over time.

Benefits of the Fixed Rate Mortgage

With a fixed-rate mortgage, the rate stays the same throughout the life of the loan. This means that the monthly mortgage payment does not change (compared to an adjustable-rate mortgage.) Many borrowers choose a 30-year fixed for affordability and predictability.

Rates can be significantly different depending on the loan type that you choose.

Adjustable-Rate Mortgage

The interest rate of an adjustable-rate mortgage (ARM) will fluctuate, depending on market conditions. However, typically you will have a certain number of years at the beginning of the loan period when the interest rate is fixed. For example, in a 5/6 ARM, your rate is fixed for 5 years, with a rate adjustment every 6 months for the life of the loan thereafter. 

With an adjustable-rate mortgage your monthly mortgage payment could go up or down to account for changes to the interest rate.

Benefits of the Adjustable-Rate Mortgage

Interest rates for ARMs are generally lower than interest rates on fixed-rate loans, at least for a few years. Another benefit of an ARM is that if you have a high debt-to-income ratio (DTI), you may have an easier time qualifying than with a fixed-rate mortgage. Learn more about DTI here.  

How Do Points Work in a Mortgage?

A mortgage point is equivalent to 1% of your total loan amount. Therefore, on a $100,000 loan, one point would be $1,000.

You can choose to pay mortgage points up front in exchange for a lower interest rate and monthly payments. This is known as “buying down” your interest rate.

Your monthly mortgage payment will depend on your home price, down payment, loan term, property taxes, homeowners’ insurance, and interest rate on the loan (which is highly dependent on your credit score).

Your loan officer can provide additional expertise and help take the guesswork out of mortgage interest rates. Contact them today for help on finding the right loan.