How Does Mortgage Interest Work?

What Is Mortgage Interest?

A mortgage loan is a significant financial commitment, both for you and the lender. When you finance the purchase of a home, you'll pay back the principal balance plus interest.

Your lender determines your interest rate based on your creditworthiness. Once you've received the loan, the rate will be applied to your balance to determine how much of your monthly payment goes toward interest and how much goes toward paying down the loan amount.

In the early years, most of your monthly payments will go toward interest. Over time, however, that portion decreases as your balance goes down.

Learn More >> What Is Interest? How It Works for Borrowing, Deposits and Investing

How Is Mortgage Interest Determined?

Interest rates on a mortgage are determined based on a number of factors, both individual and related to the market overall. 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 you may be offered based on all other factors.
• How much you borrow: The more money you borrow, the greater 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: In general, shorter loan terms across all loan types result in a lower interest rate for two reasons. For starters, 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.
• 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—meaning 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.

Learn more: Factors That Help Determine Your Mortgage Interest Rate

How Does Interest Work on Different Mortgage Types?

Mortgage interest can work a little differently depending on the type of mortgage you choose. Here's a quick summary of what you can expect with each one.

Fixed-Rate Mortgages

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.

Fixed rates tend to be higher than the starting rate for an adjustable-rate mortgage. For example, if you take out a mortgage with a 5.2% interest rate today, your rate will not increase or decrease for the life of your loan, even if mortgage rates offered on new loans go up or down.

Fixed-rate mortgages are a type of amortized loan. You pay fixed monthly payments that are applied to both the principal and interest until the loan is paid in full. In the beginning of your loan, most of your payments go toward interest. As you get closer to the end of your loan payments, this flips and most payments go toward principal.

Learn more: What Is an Amortized Loan?

Adjustable-Rate Mortgages

With an adjustable-rate mortgage (ARM), 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 depending on the current market mortgage rates. Adjustments typically occur every six or 12 months.

Example: If you take out an ARM today with a 5.2% interest rate that adjusts every 12 months (following the introductory fixed period), that means your interest rate will change every year for the life of your loan. If interest rates drop to 3%, that could mean great news for your monthly payments; on the other hand, if the interest rate increases to 7%, your payments will go up.

This option may be worth considering when rates are high or if you're not planning on staying in your home for very long.

Interest-Only Mortgages

As its name suggests, an interest-only mortgage only requires you to pay accrued interest during a certain period of time, typically three to 10 years.

Once you complete your interest-only period, you'll start making principal-and-interest payments for the remainder of your repayment term. As a result, your payments will increase significantly. Other options at the end of the interest-only period include making a balloon payment to pay off the principal balance all at once or refinancing the loan into a traditional mortgage.

Jumbo Mortgages

Jumbo loans can offer fixed or adjustable interest rates. The main difference is that interest rates on jumbo mortgages tend to be higher because they're larger than conforming mortgage loans.

How Do Mortgage Rates Affect Monthly Mortgage Payments?

With a higher mortgage interest rate, you can expect a higher monthly payment. Because mortgage loans are much larger than other types of consumer loans, even a slight change in your interest rate can have a disproportionate impact on your monthly payment and total costs.

Example: Here's a quick comparison based on a $400,000 home loan with a 30-year repayment term:

You can use Experian's mortgage calculator to get an idea of what different rates would look like for your specific situation.

Mortgage calculator

Mortgage Interest Example

Your down payment will have an impact not only on your interest rate but also on the total amount you pay. Here's a quick example of how different down payment percentiles would look with a $400,000 purchase price, a 6% interest rate and a 30-year repayment term:

Keep in mind, too, that a higher down payment could also help you secure a lower interest rate, compounding your savings even more.

How to Get a Lower Mortgage Interest Rate

While there are some variables outside of your control, you can take several steps to improve your odds of getting a lower interest rate on your next home loan. Here are some to consider:

• Improve your credit. If you're planning to buy a home in the next few years, the best time to start building your credit is now. You can start by getting access to your FICO^® Score^☉ and Experian credit report and Experian credit report for free. Doing so can help you gauge your credit health and identify areas where you can make some improvements.
• Pay down debt. Take a look at your current debt and consider ways to pay down smaller balances before applying for a mortgage. Eliminating a debt will remove its payment from your DTI calculation.
• Make a larger down payment. The more money you put down, the more skin you have in the game, so to speak. As a result, lenders may be willing to offer you a lower interest rate. What's more, if you put down 20% or more on a conventional loan, you can avoid private mortgage insurance, saving even more money.
• Choose a less expensive home. The less you borrow, the less risk you pose to the lender. Unless you can afford a higher monthly payment without sacrificing other important financial objectives, try to limit your house budget.
• Opt for a shorter term. If you can afford a higher monthly payment, you could score a lower rate by choosing a 15-year term instead of a 30-year term.
• Buy down the rate. If you're planning to keep the mortgage for a long time, consider buying discount points to reduce your rate. Each point typically costs 1% of the loan amount and reduces your rate by 0.25%.

Learn more: How to Get Your Credit Ready for a Mortgage

Frequently Asked Questions

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.