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How Does Mortgage Interest Work?

tl;dr

What You Need To Know

  • Mortgage interest is what a lender charges for lending you money to buy a home. It is a percentage of your mortgage loan
  • If you have a low credit score, your lender will likely quote you a higher interest rate
  • There are four types of mortgage loans: fixed-rate, adjustable-rate, interest-only and jumbo loans

Contents

Buying a home can be challenging. From figuring out the right time to buy a home to figuring out how to buy a home (all while learning insider mortgage lingo in your spare time), it’s a lot. 

It may look like madness, but, trust us, there’s a method to the “madness.” 

Your home (because we are manifesting right now!) will probably be the largest financial investment you ever make. We want you to be well informed and feel confident when it comes time to make decisions about mortgages (aka the loan you need to get a home) and getting the best home mortgage interest rate you can.

What Is Mortgage Interest?

It’s crucial that you understand what mortgage interest is. It’ll help you understand how your monthly payments are calculated, and it will help you know how much the loan will ultimately cost.

Mortgage interest is the fee you pay your lender to borrow money to buy a house – and it makes up a big part of your monthly payments.

When you take out a mortgage loan, you agree to pay the loan back every month over the loan’s repayment period. Each monthly mortgage payment is a combination of principal (the amount of money you’re borrowing) and interest (the fee on the amount of money you’re borrowing). 

The principal portion of your monthly payments pays down the balance of your loan. The interest portion of your monthly payments (which is usually expressed as a percentage of your loan) is a charge that gets tacked onto your principal payment and makes up the rest of your monthly payment.

What Factors Into a Mortgage Rate?

Mortgage interest will be different from one homeowner to the next because lenders determine interest rates based on a variety of factors. Some of these factors will be unique to you, like your financial situation and the type of property you’re buying. Other factors, like inflation or real estate market forces, will be out of your control.

Because lenders aren’t all alike, the interest rates you’re offered won’t be either. While you’re in the “consideration stage” with lenders, comparing the interest rates you’re quoted can help you decide which lender you want to get a mortgage loan from. 

Factors in your control

  • Credit score: Lenders typically offer lower interest rates to borrowers with credit scores of 740 or higher. If your score is lower than that, the rates are typically higher. (FYI: If yours is in the lower range, first, don’t panic! Second, there are tried-and-true ways to improve your score.)
  • Length of the loan (aka loan term): No matter what type of mortgage loan you get, if you repay the loan over a shorter amount of time, you’ll get a lower interest rate. 
  • Loan-to-value (LTV) ratio: This is how lenders measure what you owe on your mortgage compared to your home’s value (think: your loan divided by the home’s value). The larger your down payment, the lower your LTV. A high LTV – especially when combined with a lower credit score – might mean a higher mortgage interest rate or having to pay for private mortgage insurance (PMI).
  • Type of property or loan: Some lenders have higher interest rates for certain types of loans, including loans on factory-made homes, condos, second homes and investment properties.

Factors out of your control

  • State of the economy: When the economy slows, economic activity stalls. Mortgage interest rates will typically drop to encourage buying and borrowing.
  • Inflation: When prices go up (or inflate), the U.S. dollar loses purchasing power. To combat inflation, the Federal Reserve may raise rates. 
  • Real estate market: When there are fewer homes being built or fewer homes for sale, the drop in home buying leads to a decrease in the need for mortgage loans – and that leads to a dip in interest rates, too.

How Is Interest Calculated on a Mortgage?

As a borrower, you will make a monthly mortgage payment to repay your loan. Each payment is a combination of principal and interest. 

To figure out your monthly payment, lenders use a process called amortization. Amortization is a schedule of your payments over your entire repayment period. Lenders figure out how much of your monthly payment will pay down the principal and how much will go to interest. 

But here’s the catch – what goes toward principal and interest doesn’t stay the same over the life of the loan.

When you first start paying back the loan, the majority of your monthly mortgage payment will go toward paying back the interest. Because your loan balance is bigger at the beginning of your repayment period, your interest fees will be higher. As time goes on and you continue making payments, your principal balance will shrink and the amount of your payment applied to interest will shrink, too. 

Amortization schedule

The schedule is a comprehensive breakdown of your monthly loan payments. You can use a set of formulas to calculate payments for each period of your amortization schedule, but we HIGHLY recommend using an amortization calculator. 

Your full amortization schedule will give you a few key details:

  • The total amount of interest you’ll pay on the loan over time
  • The amount of interest and principal you’ll pay each month
  • Your total loan balance at the end of each month. (Pro tip: Knowing this will help later on if you pay private mortgage insurance and want to figure out when you’ll achieve an 80% LTV ratio to get rid of it.)

Let’s say, for example, that you got a mortgage for $200,000 with a 30-year fixed-rate mortgage and a 4% interest rate. Here’s what your amortization schedule would look like during the first year of payments:

MonthPaymentInterestPrincipalBalance
$200,000
1$954.83$666.67$288.16$199,711.84
2$954.83$665.71$289.12$199,422.71
3$954.83$664.74$290.09$199,132.62
4$954.83$663.78$291.06$198,841.57
5$954.83$662.81$292.03$198,549.54
6$954.83$661.83$293.00$198,256.54
7$954.83$660.86$293.98$197,962.57
8$954.83$659.88$294.96$197,667.61
9$954.83$658.89$295.94$197,371.67
10$954.83$657.91$296.93$197,074.75
11$954.83$656.92$297.91$196,776.83
12$954.83$655.92$298.91$196,477.93
Source: Rocket Mortgage®

Compound interest

Here’s another thing you should be aware of: Mortgage interest compounds. That means that interest is added back to the principal. 

Compound interest is calculated with the principal amount plus the accumulated interest of the past payment periods, which means you’re paying interest on the interest.

As we mentioned earlier, because the principal is a small portion of your monthly mortgage payment in the beginning, a smaller amount of the loan balance gets paid off. 

The Impact of Interest Rates on Different Types of Mortgage Loans 

When you’re shopping around for mortgage quotes, you’ll find that most financial institutions, banks, and lenders typically offer two types of loans: fixed-rate and adjustable-rate loans. 

Two loan types are less well known, but you should know them, too. They are interest-only and jumbo loans.

Fixed-rate mortgage loan

With a fixed-rate mortgage, the interest stays fixed (think: stays the same) throughout the repayment period. So, how much you pay each month never changes. The most common repayment period is 30 years, but lenders also offer 10, 15, and 20 years. 

If you can afford it, consider getting a shorter loan term. Yes, your monthly mortgage payments will be higher, but you’ll pay less in interest over the life of the loan. 

Adjustable-rate mortgage (ARM) loan

With an adjustable-rate mortgage (or variable), the interest rate can adjust (think: change) based on the state of the market. ARMs typically come with a low interest rate (lower than a fixed-rate mortgage) that can last 3 – 7 years. 

If the rate changes, depending on the terms of your loan, your lender will adjust your monthly payment. 

ARMs are a solid option for borrowers who want a shorter repayment period and plan on taking full advantage of the lower interest rate at the start of the loan’s repayment period. 

Interest-only loan

Though you may have guessed it from the name, an interest-only loan allows borrowers to only pay the interest on the loan for the first few years of the repayment period, so they’ll have lower monthly payments. 

If you’re not planning on living in the home for a long time and you plan on selling before the higher monthly payments kick in, an interest-only loan could be a solid choice. One thing to consider is that if the home loses value, you might end up paying more for the home than it’s worth. 

Jumbo mortgage loan

Another mortgage loan you may have never heard of is a jumbo loan. Jumbo loans finance expensive homes that are over conventional mortgage loan lending limits. (FYI: Conventional mortgage loans are what most people think of when they think about buying a home.)

The max amount for a conforming loan varies based on location but can range from $548,250 – $822,375.[1] Any home that goes over the local conforming loan limit needs a jumbo loan.

Bottom Line

Now that you understand how mortgage interest works, you’re better equipped to make smarter financial decisions. 

If you don’t like the interest rates lenders are quoting you, you can do something about it! You can work on ways to raise your credit score to help you qualify for lower interest rates.

  1. Federal Housing Finance Agency. “FHFA Announces Conforming Loan Limits for 2021.” Retrieved October 2021 from https://www.fhfa.gov/Media/PublicAffairs/Pages/FHFA-Announces-Conforming-Loan-Limits-for-2021.aspx

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In Case You Missed It

Take-aways

  1. In the beginning, the amount of your monthly mortgage payment that goes toward interest is higher than the amount that goes toward your principal balance
  2. To figure out how much you’ll spend over the life of your loan in interest and principal, you can calculate an amortization schedule
  3. If you want a lower interest rate, you can opt to buy mortgage discount points

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