How Interest Rates Work on a Mortgage

One of the biggest purchases a homeowner will take is getting a home mortgage. When shopping for a mortgage, it’s helpful to understand how interest rates work. Here’s some information that explains what interest rates are and how they are applied in a mortgage.

What Is An Interest Rate?

Interest is calculated as a percentage of the mortgage amount. The longer you have to pay off your mortgage, the more interest you’ll pay over the lifetime of the loan. Interest can actually cost nearly as much as the mortgage over time.

Lenders charge interest rates based on the risk they are taking when issuing a loan. The riskier it seems to loan the money, the higher the interest rate. You’ll have to pay this back in addition to the mortgage. The total cost you have to pay, including interest, fees, and points, is called Annual Percentage Rate (APR).

Mortgage payments are structured so that interest is paid off sooner, with the bulk of mortgage payments in the first half of your mortgage term going toward interest. As the loan amortizes, more and more of the mortgage payment goes toward the principal and less toward its interest.

How Is Interest Applied in a Mortgage?

Fixed-Rate Mortgages

Fixed-rate mortgages are the most popular type of mortgage. Fixed-rate mortgages have a monthly payment that is the same for the entire life of the loan. The interest rate is locked in and does not change.

Loans have a repayment life span of 30 years; shorter lengths of 10, 15 or 20 years are also available. Shorter loans will have larger monthly payments that are offset by lower interest rates and lower overall cost.

Quick Facts:

• If interest rates change, your mortgage payment won’t be affected. You know what your principal and interest payment will be for the term of the loan.
• The interest rate may be higher than other types of loans.
• Your monthly payment can change based on taxes and homeowner’s insurance.

Adjustable-Rate Mortgages

The interest rate for adjustable-rate mortgages are not locked in and will change over the life of the loan. Most ARMs have a limit on how much the interest rate may fluctuate, as well as how often it can be changed. When the rate goes up or down, the lender adjusts your monthly payment so that you’ll make equal payments until the next rate adjustment occurs.

Quick Facts:

• All ARMs have periods that limit when the interest rate can change. The interest rate doesn’t change for the first period. This can range from 6 months to 10 years. After the first period, most ARMs adjust the interest rate from time to time.
• Interest rate changes are based on the current market, so if the interest rate increases, your payment will increase.
• All ARMs limit how much the interest rate changes over the life of your loan.

Interest-Only

With interest-only loans, you only have to pay the interest on the amount you have borrowed for the loan. After a set period of time the loan changes to a principal and interest loan. The principal is not reduced in the normal payments. The interest-only payment period is typically between 3 and 10 years.

The Bottom Line

It’s important to understand how interest rates work so you can calculate the cost of your debt. Knowing how much interest you are paying over time can help you to seek lower interest rates or pay off the debt at a faster rate.