How Does Mortgage Interest Work?
Buying a home is the largest purchase most people will make in their lifetime. So, it’s critical to understand the ins and outs of the transaction, primarily how mortgage interest works. Mortgage interest is the money you pay the lender for servicing and issuing the loan. While this definition may sound simple, understanding mortgage interest can be complex.
First-time and even seasoned home buyers typically ask their mortgage lender many questions during the home buying process, such as “What is the interest rate on a mortgage?” and “What factors determine mortgage interest rates?”. Fortunately, the experts at Griffin Funding can help answer these questions and more. Let’s take a deep dive into how mortgage interest works.
- Your monthly mortgage payment includes principal and interest.
- The mortgage rate and annual percentage rate are different. The latter is typically higher because it includes additional fees.
- The loan amortization schedule shows you a complete table of your loan payments and how the overall balance changes with each installment.
- Many factors can influence your interest rate, including your credit score and loan amount.
- There are many types of mortgages, including fixed-rate, adjustable-rate mortgages, and interest-only mortgages. Each mortgage offers pros and cons.
Basics of Mortgage Interest
Anytime a lender issues a loan, they must assume a certain level of risk. Even if you have excellent credit and an impeccable history of repaying your debts, the risk exists that you will lose your income, get sick, or become incapable of paying your debts. If the unexpected happens, the lender will be left holding the bad debt. This risk is the reason you pay interest on mortgages.
Interest is a fee designed to compensate the lender and cover lending costs. Lenders calculate your mortgage interest as a percentage of your loan.
The principal is the amount of your loan or amount borrowed to make the purchase. For example, if you purchase a home for $300,000, your principal balance on your mortgage would be $300,000.
The interest rate is money you pay to your mortgage lender in exchange for giving you the loan. Most lenders determine your mortgage interest rate in terms of the annual percentage rate (APR) — the actual loan cost annually. The APR may include:
- The interest rate
- Mortgage broker fees
- Closing costs
- Any other charges you pay to get the loan
Because of this, your mortgage APR will typically be higher than the stated mortgage interest rate.
How Does Interest on a Mortgage Work? The Amortization Schedule
The loan amortization schedule shows a complete breakdown of your loan payments and how the overall balance changes with each installment. While your monthly mortgage payment is fixed, how the payment is split between principal and interest can change, which is shown by the amortization schedule.
Most of your beginning mortgage payments will go towards interest with little impact on the principal balance. Over time, an increasing amount of your payment will go towards the principal balance until you’ve completely repaid the loan.
How Is Mortgage Interest Calculated?
Understanding how mortgage interest works and is calculated is vital. Make sure to pay special attention to the APR. Some lenders may offer you a lower interest rate but have higher upfront fees, which can drastically increase your mortgage APR.
To calculate your mortgage interest, lenders multiply your total balance by the annual interest rate. Then, this number is divided by 12 because you’ll make monthly payments.
For example, if your principal balance is $300,000 and your rate is 4%, you’ll multiply $300,000 by 0.04, which equals $12,000 in interest. Next, divide the total interest by 12 to calculate a monthly interest tab of $1,000.
Factors Influencing Mortgage Interest Rates
Considering how interest impacts your monthly payment, it’s critical to understand the factors that dictate your interest rate. These factors include:
- Credit score: The lower your credit score, the more risky a lender will perceive you, and the higher your interest rate. In contrast, people with higher credit scores tend to receive lower interest rates.
- The location of the home: Mortgage lenders offer different interest rates based on the state the property is located.
- Loan amount: Lenders may charge higher interest rates on particularly large or small loans.
- Down payment: Larger down payments can lead to a lower interest rate. When you make a larger down payment, the lender sees it as if you have more “skin in the game,” which reduces the risk they must assume.
- The term of the loan: Longer-term loans tend to have higher interest rates. For instance, the 30-year interest rate will almost always be higher than the 15-year mortgage rate.
- The type of interest rate. There are two basic types of interest rates: adjustable and fixed. Adjustable rates change with the market, while fixed-rate mortgages remain consistent over the life of the loan.
- Economic factors: Economic indicators like employment rate and gross domestic product (GDP) can influence mortgage rates.
- Loan-to-value ratio. The loan-to-value is an expression of the outstanding loan amount to the value of the home. Lower loan-to-value ratios can signal a less risky loan, which often warrants lower interest rates.
Types of Mortgages
When it comes to mortgages and interest rates, there are no one-size-fits-all solutions. Instead, there are many types of mortgages for specific situations and applications.
As the name suggests, fixed-rate mortgages have set interest rates that do not change. Fixed-rate mortgages are ideal for borrowers who want a predictable, set monthly payment for the life of the loan. A few key benefits of fixed-rate mortgages include:
- Consistent, steady interest rate throughout the life of the loan
- Easier to budget
- No early payment penalties
- Excellent for long-term homeowners
While fixed-rate mortgages offer many benefits, they may not be appropriate for every borrower. Potential disadvantages of fixed-rate mortgages include:
- Higher than adjustable-rate loans, particularly in the beginning
- Increased qualification difficulty
- Higher monthly payments
- They’re not ideal for short-term homeowners
Adjustable-rate mortgages (ARMs) feature variable interest rates, which means they change. Most ARMs have an initial or introductory interest rate that will remain fixed for a specific period, such as three, five, seven, or 10 years. Afterward, the interest rate adjusts based on the index. In many instances, the interest rate will increase, which can cause your monthly payment to increase. A few key benefits of ARMs include:
- May offer lower interest rates in the beginning
- The interest rate could decrease later
- They’re a more suitable option for short-term homeowners
On the other hand, there are a few considerations you should make before taking an ARM, such as:
- It can be riskier because your rate and monthly payment can increase.
- It can be harder to budget for after the interest rate begins to adjust.
- It’s not necessarily a good solution for long-term homeowners.
Interest-only mortgages require you to pay the interest for a specific period of time. The principal will be paid as a lump sum on a specified date or in subsequent payments. Interest-only mortgages cater to the unique needs of specific buyers in certain situations. Most interest-only borrowers have:
- Increasing income
- High monthly cash flow
- Large cash savings
An interest-only mortgage is typically best suited to buyers in a strong financial position who plan on owning the property for a short period, such as 5 to 10 years. Interest-only mortgages can also be perfect for someone who earns large annual bonuses at work and utilizes those bonuses to pay the principal down. However, interest-only mortgages aren’t suitable for the typical long-term or first-time buyer.
Secure the Best Mortgage Interest Rate
Purchasing a home is a monumental decision that can have generational implications. As such, it’s critical to pay attention to the details and understand how mortgage interest works.
Fortunately, the experts at Griffin Funding can help. At Griffin Funding, we are a leading mortgage and home lender offering all types of mortgages, including conventional loans, FHA loans, USDA loans, and more.
Whether you’re looking to purchase your first home, a vacation home, or investment property, your Griffin Funding mortgage expert will guide you through the process, ensure you understand your options, and help you make the best decision based on your unique financial situation. Contact Griffin Funding today to secure the best mortgage interest rate.
Frequently Asked Questions
What is a good mortgage interest rate?
Because mortgage rates regularly change, what’s considered “good” is a sliding window. However, if you’re looking for a mortgage, one good rule of thumb is to get at least three offers to compare rates based on your financial profile and credit score.
Can you lower your mortgage interest rate?
Yes, lowering your interest rate through a mortgage refinance may be possible. For example, if you purchased your home when interest rates were higher and your credit score was lower, you may be able to refinance with lower interest rates.
How frequently do mortgage interest rates change?
Mortgage rates constantly change — weekly, daily, and even hourly. The economy, the Federal Reserve Board, and inflation are all factors that cause mortgage rates to remain in flux. Consider locking the rate in if you find a competitive mortgage interest rate with a trustworthy lender.
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