When you buy a home with a mortgage, you don't just pay back the amount you borrowed, known as the principal. You also pay interest on the loan amount you haven't yet repaid. This is the cost of borrowing money. How much you will pay in mortgage interest varies depending on factors like the type, size, and duration of your loan, as well as the size of your down payment and your own credit history.
Typically, a bank or other mortgage lender will finance 80% or more of the price of the home, and you agree to pay it back—with interest—over a specified period. As you compare lenders, mortgagerates, and loan options, it's helpful to understand how different mortgages work and which kind may be best for you.
Key Takeaways
- When you have a mortgage, you pay interest on the amount of the loan that you haven't yet repaid to your lender.
- Two basic types of mortgages are fixed-rate, in which the interest rate stays the same, and adjustable-rate, in which the interest rate can change over time.
- As you repay the principal of your loan, the amount of interest you will need to pay each month decreases, with more of the payment going toward your equity in the home.
:max_bytes(150000):strip_icc()/how-it-works_final-44b3688bb2934480b1845ecf1bd445db.png "How Does Mortgage Interest Work? (1)")
Mortgage Interest vs. Principal
Each mortgage payment you make will have two parts. The principal is the borrowed amount you haven't yet paid back. The interest is the cost of borrowing that money. Mortgage interest is calculated as a percentage of the remaining principal.
With most mortgages, you pay back a portion of the amount you borrowed (the principal) plus interest every month. Your lender will use anamortizationformula to create a payment schedule that breaks down each monthly payment into principal and interest.
When you first start making mortgage payments, you will likely pay more each month in interest than you do on the loan's principal. But, as you make payments, the principal you haven't repaid decreases. This means that the interest you pay each month will also decrease, allowing more and more of your mortgage payment to go toward repaying the principal and building equity in your home.
If you make payments according to the loan'samortization schedule, the loan will be fully paid off by the end of its set term, such as 30 years. If the mortgage is a fixed-rate loan, each payment will be an equal dollar amount. If the mortgage is an adjustable-rate loan, the payment will change periodically as the interest rate on the loan changes.
The term, or length, of your loan, also determines how much you'll pay each month. The longer the term, the lower your monthly payments will typically be. The tradeoff is that the longer you take to pay off your mortgage, the higher the overall purchase cost for your home will bebecause you'll be paying interest for a longer period.
Fixed-Rate Interest vs. Adjustable-Rate Interest
Lenders set your interest rate based on various factors that reflect how risky they think it is to loan you money. For example, you will likely have to pay a higher interest rate if you have a lot of other debts, an irregular income, or a low credit score. This means that the cost of borrowing money to buy a house is higher.
Conversely, you are more likely to be offered a lower interest rate if you have a high credit score, few or no other debts, and a reliable income. In that case, the overall cost of your mortgage will be lower.
Your mortgage interest rate is also impacted by the type of mortgage you get. Banks and other lenders primarily offer two basic types of loans:
- Fixed-rate.The interest rate is set when you take out the mortgage and does not change.
- Adjustable rate.The interest rate you start with will change under defined conditions. (These are also called variable rateorhybridloans.)
Here's how the two types work.
Fixed-Rate Mortgages
With this type of mortgage, the interest rate is locked in for the life of the loan and does not change. The monthly payment also remains the same for that entire time. Loans often have a repayment life span of 30 years, although shorter lengths of 10, 15, or 20 years are also widely available. Shorter loans require larger monthly payments but have lower total interest costs over time.
Example: A $200,000fixed-rate mortgagefor 30 years (360 monthly payments) at an annual interest rate of 6.5% will have a monthly payment of approximately $1,264. (Real-estate taxes, private mortgage insurance, and homeowners insurance are additional and not included in this figure.) The 6.5% annual interest rate translates into a monthly interest rate of 0.542% (6.5% divided by 12). So, you'll pay 0.542% interest each month on your outstanding loan balance.
When you make your first payment of $1,264, the bank will apply $1,083 to the loan's interest and $181 to the principal. Because the principal you owe is now a little smaller, the second monthly payment will accrue a little less interest, so slightly more of the principal will be paid off. By the 359th payment, almost the whole monthly payment will apply to the principal.
Adjustable-Rate Mortgages (ARMs)
Because the interest rate on an adjustable-rate mortgage is not permanently locked in, the monthly payment can change over the life of the loan. MostARMshave limits or caps on how much the interest rate can fluctuate, how often it can be changed, and how high it can ever go. When the rate goes up or down, the lender recalculates your monthly payment, which will then remain stable until the next rate adjustment occurs.
As with a fixed-rate mortgage, when the lender receives your monthly payment, it will apply a portion to interest and another portion to the principal.
Lenders often offer lower interest rates for the first few years of an ARM, sometimes called teaser rates, but these can change after that—as often as once a year. Because the initial interest rate for an ARM tends to be lower than that of a fixed-rate mortgage, ARMscan be attractive if you plan to stay in your home for only a few years.
If you're considering an ARM, find out how its interest rate is determined; many are tied to a certain index, such as the rate on one-year U.S. Treasury bills, plus a certain additional percentage or margin. Also, ask how often the interest rate will adjust. For example, a five-to-one-year ARM has a fixed rate for five years. After that, the interest rate will adjust each year for the remainder of the loan period.
Example: A $200,000 five-to-one-year adjustable-rate mortgagefor 30 years (360 monthly payments) might start with an annual interest rate of 6% for five years, after which the rate is allowed to rise by as much as 2% (the annual cap). The payment amount for months 1 through 60 would be $1,199 per month. If it then rises by 2% and is now 8%, the payment for months 61 through 72 would be $1,468, after which the payment could change again. (Again, taxes and insurance are not included in these figures.)
Interest-Only Mortgages
A much rarer third option is aninterest-only mortgage.These are usually reserved for wealthy homebuyers or buyers with irregular incomes.
As the name implies, this type of loan allows you to pay only interest for the first few years, resulting in lower monthly payments. It might be a reasonable choice if you expect to own the home for a relatively short time and intend to sellbefore the bigger monthly payments begin. However, you won't build any equity in the home during the time you are only paying back interest. If your home declines in value, you could owe more than it is worth.
Jumbo Mortgage Loans
A jumbo mortgage is usually for amounts over the conforming loanlimit, which can change each year. In 2024, this limit is $766,550 for most parts of the U.S. and $1,149,825 for high-cost areas.
Jumbo loans can be either fixed or adjustable. Their interest rates tend to be slightly higher than those on smaller loans of the same type.
Interest-only jumbo loans are also available, though usually only for the very wealthy. They are structured similarly to an ARM, and the interest-only period lasts as long as 10 years. After that, the rate adjusts annually, and payments go toward paying off the principal. Payments can go up significantly at that point.
Even with a fixed-rate mortgage, your monthly payment can change if it also includes taxes or insurance.
How Can You Get a Lower Interest Rate on a Mortgage?
The interest rate you have to pay on a mortgage depends on a variety of factors. The economic climate and interest rates set by the Federal Reserve affect mortgage rates, as do other factors that are largely beyond your control.
From there, lenders will calculate your interest rate based on your personal financial situation, such as your credit score and how much other debt you have. Anything you can do to improve your credit score or pay down debts before you apply for a mortgage could help you qualify for a lower rate.
Can You Negotiate for a Lower Mortgage Interest Rates?
Yes, especially if you shop around and have offers from multiple lenders. Another way to negotiate a lower interest rate is to agree to pay points. Points are a form of prepaid interest that a lender may accept in return for offering you a lower interest rate.
What Credit Score Do You Need to Get a Mortgage?
In general, most lenders look for a credit score of at least 620. However, there are exceptions, such as Federal Housing Administration (FHA) loans that will accept a credit score as low as 500 in some cases.
Will Refinancing Your Mortgage Get You a Lower Rate?
If mortgage rates have fallen since you took out your mortgage, or if your credit score has improved substantially in the meantime, you may qualify for a new mortgage with a lower interest rate. You could then pay off your old mortgage and make payments on the new one going forward. However, you'll most likely have to pay closing costs on the new mortgage, which can negate any savings, so it's worth doing the math to see if refinancing really makes sense.
The Bottom Line
If you're looking for a mortgage, you will have several different types to choose from. Whichever one you decide to go with will have a large effect on the interest rate you have to pay. There are also trade-offs to consider, especially when you're comparing fixed-rate vs. adjustable-rate mortgages. Paying less interest in the short term could mean paying more in the long term.
