How Does Mortgage Interest Work?
Ashley Kilroy7-Minute Read
June 22, 2023
One of the biggest hurdles for prospective homeowners is finding the right mortgage. And one of the things that can make or break an affordable mortgage is the interest rate. Home loan interest rates can severely impact your long-term costs, so most buyers look for the lowest rates possible. But not every lender or loan is the same.
It would help if you explored the question, “How does mortgage interest work?” before agreeing to any financing. Here’s what you should know so you can get the best mortgage rate and choose the loan type that suits your needs.
Why You Have To Pay Interest On Mortgage Loans
When you borrow money to buy a home, you need to repay the institution that lent those funds. But you have to return more than the original amount you borrowed, or the principal. Your lender will also charge you interest on the loan. This is essentially a fee to cover the cost of lending in the first place.
Your lender calculates your mortgage interest as a percentage of your loan. They do this based on a variety of factors, such as your credit score and down payment amount, which can significantly impact how high or low your interest rate will be.
If you make your loan payments according to your amortization schedule, you will fully pay off the loan by the end of its term. However, attractive interest rates may encourage homeowners to consider paying off their mortgage early. And it helps to understand how mortgage interest works if that route appeals to you. By making additional payments toward your principal, you can reduce the amount you need to pay interest on, saving you thousands of dollars and shortening your loan term.
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How Lenders Calculate Your Mortgage Payments
Multiple factors contribute to your monthly mortgage payment. By breaking it down, you can better understand principal and interest along with other crucial costs. Some you should know include:
- Principal: The principal is the original amount you borrow. A portion of your mortgage payment goes toward it each month, starting out small. As you pay your mortgage, the amount increases, and the portion you put toward interest decreases.
- Interest: Interest essentially acts as a fee for taking on the risk of loaning you money. Your interest rate, which is a percentage of your mortgage amount, directly impacts how much you pay in total. A fixed-rate mortgage only has one rate, but adjustable-rate mortgages fluctuate depending on market indexes. Your interest may also compound, meaning interest builds on top of your original loan balance and previously built interest.
- Taxes: Some homeowners may pay real estate or property taxes as part of their monthly mortgage payments. The total due splits into monthly payments that you make over the year. Your lender collects them and holds them in escrow until tax time.
- Insurance: Certain borrowers may have to pay mortgage insurance in addition to their regular mortgage repayment. This typically applies to borrowers who put less than 20% down, or those with FHA loans.
- Term/length: Most mortgages come with 15-, 20-, or 30-year terms. The longer your term/length, the higher your interest rate will probably be. However, since the payments spread out over a longer time, your monthly payments will likely be lower.
- Amortization: A mortgage loan comes with an amortization schedule that determines how much you pay per month and the costs that payment covers. A basic mortgage payment goes toward two components: interest and principal. Most of your payment covers interest in the beginning, but as time goes on, the majority shifts to your principal. Homeowners can consult their lender for their amortization schedule and the calculations involved.
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How Interest Works For Different Types of Mortgages
There is a wide range of potential borrowers who need loans to buy a home. And each borrower has unique financial needs. Because of this, there are also various types of mortgages available to address those needs. Here are some options you may run into and how interest works with each of them:
Home buyers will typically have to decide between a fixed-rate mortgage and an adjustable-rate mortgage. In the case of a fixed-rate mortgage, your home loan comes with a set interest rate for its entire term. So, the borrower’s repayments of interest and principal stay the same from month to month.
Because of this, borrowers can plan their budget ahead of time without worrying about market changes. As a result, they are a popular mortgage option in the U.S. since they are great for stability. They can also be lower cost if you borrow when interest rates are low. However, when you take out a fixed-rate mortgage you tend to pay higher rates than you would initially with an adjustable-rate mortgage.
Borrowers thinking about a fixed-rate mortgage should know that they:
- Come with a locked interest rate so you’ll know what your monthly payments will be. Any changes are usually a reflection of a change in taxes or insurance
- Have lifespans of 10 – 30 years (or even 8 years with a Yourgage®)
- Often require lower interest rates when the loan term is shorter
- Apply more of earlier payments to interest; more goes to the principal as time goes on
- Can often be a higher rate than an ARM over time
- Are generally good for those who plan to stay in the home long-term
Adjustable-Rate Mortgages (ARMs)
Adjustable-rate mortgages, or ARMs, are home loans that come with an interest rate that changes over time. Market indexes determine whether the interest rate increases or decreases each time it changes. The frequency of these fluctuations depends on your agreement with your lender.
ARMs usually start out with competitively low interest rates, at least for the initial 5-, 7- or 10- years. However, that period won’t last forever, and the changes can make it difficult to budget. Essentially, you exchange the stability of a fixed-rate mortgage for the potential savings that an ARM can offer.
Borrowers interested in adjustable-rate mortgages should know that:
- Monthly payments change over the life of the loan
- They typically have caps on how much rate can change
- ARMs often charge less during their introductory period compared to fixed-rate mortgages
- ARMs use different benchmarks, such as the U.S. Treasury or the secured overnight finance rate (SOFR)
- There are different arrangements to choose from, like 5/1 and 5/6 ARMs or 10/1 and 10/6 ARMs
- They are often good for those who plan to stay in a home for a few years
Since interest costs on an ARM can drastically increase, make sure you talk to your lender before you agree to one. Ask how the lender determines their interest rate and ensure you are comfortable with that.
Jumbo Mortgage Loans
You might be looking at properties in some of the more expensive housing markets. In that case, you may need a jumbo loan. Home buyers use jumbo loans when they need a mortgage larger than conventional conforming loan limits allow. That’s why jumbo loans are considered nonconforming; they don’t conform to normal limits.
The baseline limits on conforming loans sit at $726,200 for 2023, as determined by the Federal Housing Finance Agency (FHFA). But limits change from county to county. So, if you find a higher-end property that requires a loan larger than your county limit, you may want to look for a lender that offers jumbo mortgages.
Borrowers interested in jumbo loans should know that they:
- Are riskier for mortgage lenders because they can’t be guaranteed by Fannie Mae or Freddie Mac
- Have stricter qualification rules
- Are for loans over the conforming loan limit
- Can be fixed or adjustable
- Often come with interest rates slightly higher than other loans
If you need help finding the conforming limits in your area, check out this FHFA map.
How Mortgage Interest Deduction Works
Bills, taxes and other living expenses can stack up, especially as a homeowner. But did you know that it’s possible to use your mortgage to reduce your taxable income? Every year that you pay your mortgage, you can take advantage of the mortgage interest deduction.
Essentially, this tax incentive allows you to count interest paid on your mortgage against your taxable income. As a result, you can lower the overall taxes you owe. This is good for the first $1 million of mortgage debt for a primary or secondary home bought between October 13, 1987, and December 16, 2018. However, homeowners who bought their property after 2017 may only deduct interest paid on the first $750,000 of the mortgage. That becomes $500,000 and $375,000, respectively, if married and filing separately, though.
You may need to see what qualifies as mortgage interest for your taxes, though. A debt you use to purchase your home may not qualify if it isn’t secured by the home. There are also rules that determine your eligibility. For instance, you cannot deduct mortgage interest if you take the standard deduction. You must itemize your deductions. And it isn’t a dollar-for-dollar reduction. Instead, the mortgage interest deduction depends on your tax bracket.
Let’s go over an example. Say you spent $10,000 on mortgage interest and paid taxes at an individual income tax rate of 22%. You would be allowed to exclude $10,000 from your income tax liability, saving you $2,200 (.22*10,000).
Itemized deductions also allow you to deduct PMI, late payment fees, mortgage points, and prepayment penalties.
The Bottom Line
Mortgage interest can be a significant cost for homeowners in the long run. That’s why it’s vital to explore your options. For instance, you may not need a fixed-rate loan if you don’t intend to live on your property long. You can take advantage of the introductory low-interest cost of an ARM instead. Or, you may need to prepare yourself for the possible interest rate on a jumbo loan if you are looking at higher-priced properties.
In the end, it all depends on your needs. If you’re ready to take the next step to buy a home, begin your application online with Rocket MortgageⓇ.
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