How Does Mortgage Interest Work?

Quick Answer

The interest rate on your mortgage loan is amortized over your loan's term, determining how much interest accrues each month as you pay down your balance.

Mature Couple working on their home finances. They are working at the dining room table using a calculator. There is some paperwork on the table. Close up tight crop.

When you borrow money to buy a home, interest is a significant factor in the total cost of the 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, including your creditworthiness, current market rates, the type of loan and more. If you want to minimize your interest costs, it's important to understand these factors and how you can influence them in your favor.

How Is Your Mortgage Interest Rate Calculated?

Here are some of the most significant factors that lenders consider when determining what your mortgage interest rate will be.

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 condition of the lending market all make a difference. Whatever the market interest 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 land you a lower rate, the smaller loan will save you money on interest.

Repayment Term on the Loan

In general, shorter loan terms across all loan types result in a lower interest rate for two reasons.

The first is default risk, meaning that the longer you have to pay off a loan, the more of a risk of default you pose to the lender. Second, a longer repayment term means that the lender will have to wait longer to re-lend the money you repay to another borrower, potentially at a higher rate—this is called interest rate risk.

If you can afford the much higher monthly payments on 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.

Type of Interest Rate

Mortgage lenders often offer two types of interest rates: fixed and adjustable. In general, fixed interest rates start out higher than adjustable rates, which typically come with an initial fixed period. Over time, however, your adjustable rate can climb higher, depending on market rates.

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 what's called discount points as part of your closing costs. Discount points allow you to effectively buy a lower interest rate by paying more money upfront in the form of prepaid interest.

Fixed-Rate vs. 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.

  • Fixed-rate mortgage: With a fixed-rate mortgage, your interest rate will never change for the life of the loan. It's a great option when rates are low if you prefer a predictable monthly payment and plan to live in your home for a long time.
  • Adjustable-rate mortgage: With 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—usually 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. This option may be worth considering when rates are high or if you're not planning on staying in your home for very long.

What's Included in a Monthly Mortgage Payment?

Your monthly mortgage payment typically includes several different costs associated with your loan and homeownership, including:

  • Principal and interest: Most of your payment will go toward interest charges and paying down the principal balance of the loan.
  • Homeowners insurance: If you choose (or your lender requires), your lender will deposit a portion of your mortgage payment into an escrow account, which it will use to cover your annual homeowners insurance premium and other costs. When the premium comes due, the lender will handle the payment to the insurance company.
  • Property taxes: Property taxes are also assessed on an annual basis and can change each year if the assessed value of your property increases over time. If you opt to or are required to include property taxes in your mortgage payment, your lender will estimate what your upcoming tax assessment will be annually and take monthly payments to cover the cost. If your payments don't cover the tax bill, you'll have an escrow shortage. In this event, you may be able to pay off the shortage in a lump-sum payment, or you can spread out the payment over the following year with a higher mortgage payment. You may also end up with a surplus if your lender charged too much.
  • Mortgage insurance: If you have a conventional loan and your loan-to-value ratio (LTV) is higher than 80%, you may have to pay private mortgage insurance (PMI), which protects the lender in the event that you default on your loan. Once you've paid off 20% of your loan, you can petition to have PMI removed—lenders automatically do it once your equity reaches 22% based on the home's value at closing. Government-backed loans may also require mortgage insurance, but some programs may not allow you to remove it.

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

Amortization 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, with $1,000 of your payment going toward paying down the balance and $432 toward interest. When you make your last mortgage payment, just $5 goes toward interest.

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, DTI and several other factors to calculate your rate.

How to Get Your Credit Ready for a Mortgage

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 also 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 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.