How Does Mortgage Interest Work?

Prostock-Studio / Getty Images

Commitment to Our Readers

GOBankingRates' editorial team is committed to bringing you unbiased reviews and information. We use data-driven methodologies to evaluate financial products and services - our reviews and ratings are not influenced by advertisers. You can read more about our editorial guidelines and our products and services review methodology.

20 Years
Helping You Live Richer

Reviewed
by Experts

Trusted by
Millions of Readers

Homebuyers have two costs to consider when planning a home purchase. The first is the purchase price, which they negotiate with the sellers. The second is the cost of financing the purchase, which is defined by the interest rate set by the lender. Understanding how interest works is key to determining whether a particular home fits your budget.

What Is Mortgage Interest?

Mortgage interest is the annual fee lenders charge to loan you money, expressed as a percentage of your total loan amount. As of May 17, the average mortgage rate was 7.01% for a 30-year fixed-rate loan, according to the Mortgage Bankers Association. Considering that the average new loan size is roughly $405,000, you can see how much of an impact interest plays on your total loan cost and your monthly mortgage payment amount.

How Does Mortgage Interest Work?

To understand how mortgage interest works in practice, it’s important to know that a mortgage payment has two parts:

• The principal, which is the original amount you borrowed
• Interest due on the principal

Each payment you make pays down your principal and pays a portion of the interest, but not in equal parts. A process called amortization determines how each payment is applied.

In the early years of a loan, most of your mortgage payment goes toward interest because the interest calculation is based on the entire principal balance. As the principal balance shrinks, the balance shifts, and more of your payment goes toward the principal, accelerating the amount of equity you build with each payment.

An amortization schedule tells you in advance how each payment will be applied. If, for example, you take out a 30-year, $400,000 mortgage loan with a fixed rate of 7%, you’ll have 360 monthly payments of $2,661.21. Here’s how those payments would be applied at various points throughout the loan term.

As you can see, the portion of the mortgage payments applied to interest shrinks faster — and the amount applied to the principal grows faster — as the principal balance shrinks. The last payment brings the principal balance to $0, which makes this a fully amortizing loan.

If this was an adjustable-rate loan, the amortization schedule would be based on the initial interest rate and updated each time the rate changed.

Good to Know

Some less common loan types amortize differently.

• Graduated-payment mortgage: This is a type of fixed-rate loan that starts with a low payment that gradually increases. The way it amortizes usually results in more interest than you’d pay with a standard fixed-rate loan.
• Interest-only mortgage: All your payments go toward interest for several years. After that you make principal and interest payments for the remainder of the loan term. Unlike with a standard loan, which builds equity with the first payment, an interest-only loan builds no equity at all during the early years.
• Balloon mortgage: This is a short-term (usually five to seven years) non-amortizing loan with low payments during the loan term. Because the payments are too low to fully repay the loan by the end of the term, the borrower makes a final “balloon” payment at the end to pay off the remaining balance.

How Is Mortgage Interest Calculated?

Lenders use the following amortization formula, as provided by PenFed Credit Union, to calculate principal and interest payments:

Principal x [Interest Rate x (1 + Interest Rate)^{Loan Term}] / [(1 + Interest Rate^{Loan Term}-1]

An easier way to calculate principal and interest is to use an amortization calculator that does the math for you. The Office of Financial Readiness offers one for free on its website, located here.

What’s the Difference Between a Mortgage Interest Rate and a Mortgage APR?

The interest rate only includes the percentage of your loan amount that the lender charges to loan you the money. The annual percentage rate is more comprehensive in that it includes additional costs of borrowing money. In addition to the interest rate, the APR reflects discount points (interest you pay in advance, at closing), the lender’s origination fee and certain closing costs. Every lender uses the same factors to calculate APR, so it’s a useful tool for comparing rates when you shop for a mortgage loan.

It’s important to note that APR is notional — it’s meant to give you a clearer sense of how much it will cost you to finance your home purchase, but it’s not the interest rate you pay in your mortgage payments.

How Do Lenders Set Mortgage Interest Rates?

Mortgage lenders base rates on many factors, some of which you can influence in your favor.

Factors You Can Control

• Credit score: A high credit score tells lenders that you handle credit responsibly and are unlikely to default on your loan. Lenders reward that low risk with a lower mortgage rate. So what constitutes a good credit score? According to the Fair Isaac Corp., which developed the FICO scoring model, it’s a FICO score of 739 or higher.
• Down payment: Borrowers who invest their own cash in their home purchase might go to greater lengths to avoid foreclosure. So while you can put as little as 5% down for a standard conventional loan, you’ll pay a higher rate than you’d pay with 10% or 15% down.
• Debt-to-income ratio: A low DTI, meaning only a small percentage of your income goes toward debt payments, usually results in a lower mortgage rate. A high DTI can indicate that you’re over-extended and at greater risk of default.
• Loan amount: Very large loans are riskier to lenders, so rates are higher. And very small loans aren’t especially lucrative for lenders, so they might have higher rates.
• Length of your loan. Shorter terms, say 15 years instead of the usual 30, are less risky because borrowers pay them off faster. The difference can be substantial. The Mortgage Bankers Association’s most recent Weekly Survey, published on May 22 for the week ended May 17, revealed that the average rate on a 15-year fixed-rate loan was 0.59% lower than the average rate for a 30-year fixed-rate loan.
• Type of loan: The types of loans you might qualify for include conventional, FHA, VA and USDA, and each one can have a different rate even when all else is equal. The May 22 MBA Weekly Survey noted that the average 30-year conventional fixed-rate was 7.01% for the week ended May 17, while the average for a 30-year fixed-rate FHA loan was 6.77%. Although the MBA doesn’t track rates for VA or USDA loans, they, like FHA loans, are backed by the government, so they typically have lower rates than conventional loans, too. The highest rates are on large loans that exceed standard “conforming” limits. Jumbo rates averaged 7.18% the week ended May 17.
• Type of interest rate: The two primary types of interest rates are fixed and adjustable. Fixed rates stay the same for the entire loan term, and so do the payments. Adjustable rates change periodically, beginning a predetermined number of months or years into the loan. Compared to fixed-rate mortgages, adjustable-rate mortgages often have a lower rate to begin with, but that rate could climb when it begins to adjust. Most ARMs have a cap on the amount the rate can increase in any one adjustment and the total amount it can increase over the life of the loan.
• Location of the home: Lenders sometimes offer different rates on loans made in different states, and they might even offer different rates in urban areas vs. rural ones.
• Type of home: You’ll get a lower rate on a single-family primary home than you will on a second home or investment property.

Factors You Can’t Control

Mortgage lenders, like any other type of business, consider economic factors and market conditions when setting prices.

• The economy: Strong economies with low unemployment rates and low inflation encourage people to take out mortgage loans; weak economies and periods of high unemployment and high inflation discourage them. Mortgage rates climb and fall with those increases and declines in demand.
• Housing market: Rates moderate in neutral markets, where housing supply is in sync with housing demand. When supply exceeds demand (buyers’ market), low competition drives rates down. When demand exceeds supply (sellers’ market), high demand drives rates up.
• Federal interest rates: The federal funds rate and the prime rate influence mortgage loans. Mortgage rates tend to move in the same direction as those federal rates.
• Stock market: Mortgage rates tend to rise and fall with the stock market.

How To Qualify for the Lowest Mortgage Interest Rate

Effective management of your finances and a solid strategy for buying a home can help you qualify for the lowest possible rate.

• Improve your credit score by paying bills on time, paying off debt and avoiding applying for new credit or closing existing credit lines.
• Save up at least a 10% down payment — 20% is even better.
• Buy down your interest rate with points. A point is 1% of the loan amount, paid at closing in exchange for a lower interest rate.
• If you don’t plan to stay in your home for more than a few years, opt for an adjustable-rate mortgage.
• Consider a shorter loan term, such as 15 or 20 years
• Shop around for the best rates, using APR for comparison.

One final tip: Check to see if itemizing tax deductions would result in a lower tax liability compared to the standard deduction. You won’t pay less interest this way, but if itemizing makes sense for you, it will let you deduct your mortgage interest, including points, up to IRS limits.

Data is accurate as of June 1, 2024, and is subject to change.

Share This Article: