What to Know About How Mortgage Interest Works

Consultant / Agent and clients on a handshake at business meeting

When you borrow money to buy a home, interest is a significant factor in the cost of your loan. Mortgage interest is represented as an annual rate, which will help determine your monthly payment and how much the financing arrangement will ultimately cost you.

There are several things that go into determining your interest rate on a mortgage loan. If you want to maximize your savings, it's important to understand these factors and how you can influence them in your favor.

How Is Your Mortgage Interest Rate Determined?

When you're approved for a mortgage, the loan's interest rate will be based on the risk you pose as a borrower as well as factors related to your home, the loan and economic conditions. Because mortgage loans have long repayment terms—the most common options are 15 and 30 years—even a small change in your rate can make a difference of thousands of dollars in interest charges.

Here are some of the most significant factors that lenders review to decide your loan's interest rate:

  • Current market rates: Mortgage rates are constantly changing, and vary based on more than the individual circumstances of each loan. The lender, where you live and the state of the lending market all make a difference. Whatever the prevailing market rates are at the time you apply will essentially provide a range of rates that you may get based on all other factors.
  • How much you borrow: The more money you borrow, the more of a risk you pose to the lender. As such, buying a less-expensive house or making a larger down payment could potentially help reduce your interest rate. Even if it doesn't, it'll save you money on interest because you'll have a smaller loan.
  • Your loan term: In general, shorter loan terms across all loan types result in a lower interest rate. Again, the reason is that the longer you have to pay off a loan, the more of a risk of default you pose to the lender. If you can afford a 15-year mortgage, you'll score a lower interest rate than if you opted for a comparable 30-year loan.
  • Credit and income: The higher your credit score, the likelier your chances are of qualifying for a lower interest rate. Also, lenders will review your income and debt situation to calculate your debt-to-income ratio (DTI). If you have a low ratio—that is to say, the percentage of your income that goes toward monthly debt payments is low—it could result in a lower rate.
  • Interest rate type: Mortgage lenders often offer two types of interest rates: fixed and adjustable. With a fixed-rate mortgage, your rate remains the same for the life of the loan, and it generally starts higher than an adjustable rate. With the latter, your interest rate remains fixed for a set period. Once that period is over, it turns into a variable rate that can fluctuate with market rates. Adjustable rates typically start off lower but can ultimately cost you more if market rates climb higher than the fixed-rate alternative.
  • Closing costs: In some cases, you may be able to have the lender pay your closing costs in exchange for a slightly higher interest rate. Also, lenders typically allow you to pay "mortgage points" as part of your closing costs. Mortgage points allow you to effectively buy a lower interest rate by paying more money upfront.

With this information in mind, you may be able to gain a little more control over what your interest rate will be on a mortgage loan. For example, having enough cash to make a large down payment and pay points at closing can help you score a lower interest rate. Also, maintaining a high credit score and paying down other debts can have the same effect.

Difference Between a Fixed-Rate and an Adjustable-Rate Mortgage?

Both fixed-rate and adjustable-rate mortgages have their pros and cons, but understanding how they differ can help you determine the right fit for your needs.

With a fixed-rate mortgage, your interest rate will never change for the life of the loan. It's a great option if you prefer certainty and plan to live in your home for a long time.

If you choose an adjustable-rate mortgage, your interest rate will start off lower than a fixed-rate mortgage, and it will remain the same for a set period—say three, five, seven or even 10 years. After the initial fixed period is over, though, your rate can go up or down each year, depending on the current market mortgage rates.

There are some guardrails in place to keep your interest rate from going up too much. But it still puts most of the risk on the borrower instead of the lender.

Adjustable-rate mortgages don't provide as much certainty, but they may be worth considering if you're not planning on staying in your home for very long. For example, if you're thinking of living in a particular home for three to five years, an adjustable-rate mortgage with a five-year fixed period may be a good fit.

What Is Mortgage Amortization?

Amortization is a process lenders use to calculate how much interest you pay on a loan and when. With a mortgage loan, as with any loan, you'll pay more interest at the beginning of the loan term and more principal toward the end.

This is because your interest rate is being applied to a higher loan balance at the beginning, then as you pay more and more of the principal loan amount, the balance the rate applies to decreases, which brings down your interest charges.

Calculating amortization on a mortgage loan requires some complex formulas, and it's best to use an amortization calculator. You'll need the loan amount, interest rate and loan term. With an amortization calculator, you'll be able to see several things, including:

  • How much total interest you'll pay over the life of your new loan.
  • How much interest you'll pay each month.
  • How much interest you'll pay with a 15-year mortgage versus a 30-year mortgage, or a fixed-rate loan versus an adjustable-rate loan.
  • What your loan balance will be at the end of each month—this can help if you're paying private mortgage insurance and want to know when you'll reach an 80% loan-to-value ratio and can get rid of it.

As an example, we used an amortization calculator to run the numbers for a $300,000 loan with a 4% interest rate and a 30-year term.

The monthly payment on the loan would be roughly $1,432, but in the first month, $1,000 of that goes toward interest, and only $432 goes toward paying down your loan balance. Each month, that amount increases slightly as you pay down your balance. By year 21 the numbers have swapped, $1,000 of your payment will go toward paying down the balance and $432 goes toward interest. When you make your last mortgage payment, just $5 goes toward interest.

Before you apply for a mortgage, take some time to use an amortization calculator to understand what you're signing up for, and also to help you compare different loan terms and interest rate types to determine which is the best option for you.

How Does Your Credit Score Affect Mortgage Interest Rates?

Your credit score is an important indicator of how you've managed your debts in the past, so it's a crucial factor in determining whether you qualify for a mortgage and what your interest rate will be.

Most mortgage lenders will have a minimum credit score requirement, which can vary by lender and the type of loan you're applying for. Just because you have a high credit score, though, doesn't mean you're eligible for a low rate. Lenders will also review your credit report, debt-to-income ratio and several other pieces of information to calculate your rate.

Because your credit score is such an important factor in the mortgage process, it's crucial to take steps to get your credit ready for a mortgage. Ways to do that include:

  • Check your credit score to see where you stand and your credit report to determine if you need to address specific areas of your credit history.
  • Pay down credit card balances and other debts.
  • Avoid applying for credit in the months leading up to applying for a mortgage.
  • Make it a priority to pay your bills on time every month.
  • Dispute inaccurate information on your credit reports, if applicable.

Getting your credit ready for a mortgage can take time, but again, even a small reduction in your interest rate could save you thousands of dollars.

Continue to Monitor Your Credit After You Buy a Home

Making a good impression when applying for a mortgage loan is crucial, but it's important to remain vigilant with your credit score after you get into your home. Experian's free credit monitoring tool can provide you with a lot of the information you need to stay on top of your credit and continue to improve it.

The service provides free access to your Experian credit report and FICO® Score powered by Experian data. You'll also get real-time updates when new inquiries, accounts and personal information are added to your credit report.

With these features, you'll be in a good position to track your progress, spot issues as they arise and address them before they do significant damage to your credit score.