How Does Mortgage Interest Work? Everything You Need To Know
November 18, 2023 7-Minute Read
Author: Ashley Kilroy
One of the biggest challenges for prospective homeowners can be finding the right mortgage. And one of the main factors in determining whether a mortgage is affordable is the interest rate. Home loan interest rates can have a major impact on your long-term costs, so most buyers seek the lowest rates possible.
Looking to get the best mortgage rate and choose the loan type that best suits your needs? Find answers below.
What Is An Interest Rate On A Mortgage?
When you borrow money to buy a home, you must repay the institution that provided those funds. But you have to pay more than the original amount you borrowed, otherwise known as the principal balance. In addition, your lender will charge you interest on the loan. This is essentially a fee to cover the cost of lending, and it’s how the lender is able to continue making loans available to future borrowers.
Your lender calculates your mortgage interest as a percentage of your loan and does so based on a variety of factors, including your credit score and down payment amount – which can significantly impact your interest rate.
If you make your loan payments according to your amortization schedule, you’ll pay off the loan in full by the end of its term.
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How Is Mortgage Interest Calculated?
Multiple factors contribute to your monthly mortgage payment. By breaking it down, you can better understand principal and interest along with other crucial costs detailed below.
- 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 of your monthly payment that goes toward the principal balance increases, and the portion that goes to 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 for the life of the loan, but the rate on an adjustable-rate mortgage will fluctuate with the market. Your interest may also compound, meaning it builds on top of your original loan balance and previously built interest.
- Taxes: Most homeowners may pay real estate taxes – otherwise known as property taxes – as part of their monthly mortgage payments. The total due in real estate taxes each year is broken into monthly payments. Your lender collects these payments and holds them in escrow until tax time.
- Mortgage Insurance: Some borrowers pay mortgage insurance in addition to their regular mortgage repayment. You’ll pay mortgage insurance if you have an FHA loan or put less than 20% down on a conventional loan.
- Term/length: Most mortgages come with a 15-, 20- or 30-year The longer your term/length, the higher your interest rate will probably be. However, since the payments are 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 about their amortization schedule and the calculations
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How Does Interest Work On Different Loan Types?
There’s a wide range of potential borrowers who need a loan to buy a home, and each borrower has unique financial needs. For this reason, various types of mortgages are available to address those needs.
Below are some options you may encounter 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. With a fixed-rate mortgage, your home loan comes with a set interest rate for its entire term. The borrower’s repayments of interest and principal stay the same from month to month.
As a result, borrowers can plan their budget without worrying about market changes. This stability makes fixed-rate mortgages a popular choice in the U.S. These loans can also be lower-cost if you borrow when interest rates are low.
However, with a fixed-rate mortgage, you tend to pay a higher rate 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 as few as 8 years with a YOURgage®).
- Often require lower interest rates when the loan term is shorter.
- Apply a greater amount of earlier payments to interest, with more going to the principal balance in time.
- 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 the rate can change.
- ARMs often charge less than fixed-rate mortgages during their introductory period.
- ARMs use different benchmarks, such as the U.S. Treasury or the Secured Overnight Financing Rate (SOFR).
- Different arrangements are available to choose from, including 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 only a few years.
Since interest costs on an ARM can drastically increase, be sure to talk with your lender before you agree to one. Find out how the lender determines their interest rate and ensure you’re comfortable with it.
Jumbo Mortgage Loans
If you’re looking at properties in some of the more expensive housing markets, you may require what’s known as 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 limit on conforming loans is $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 these loans:
- Are riskier for mortgage lenders because they can’t be guaranteed by Fannie Mae or Freddie Mac.
- Have stricter qualification rules.
- Are for amounts 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
In 2017, changes to tax rules made a tax deduction known as the standard deduction a more attractive option for many taxpayers. For this deduction, which increased significantly with passage of a bill in Congress, you don’t need to submit any evidence of expenses or itemize them; you simply have to claim this standardized sum. This option is available to all taxpayers regardless of other deductions they might qualify for. When using the standard deduction, you won’t itemize deductions. Many taxpayers will find that they can save more money by claiming this one deduction – the standard deduction – than by itemizing.
However, if your itemized deductions add up to a total that exceeds the standard deduction, it’s best to claim your deductions individually instead of using the standard deduction.
Every year that you pay your mortgage, you can take advantage of the mortgage interest deduction as an itemized deduction – if you don’t claim the standard deduction.
Essentially, the mortgage interest deduction 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 after October 13, 1987, and before December 16, 2017, or $500,000 of mortgage debt if married filing separately.
However, homeowners who bought their property after 2017 may only deduct interest paid on the first $750,000 of the mortgage, or the first $375,000 if married filing separately.
Be aware that you may need to see what qualifies as mortgage interest for your taxes. A debt you use to purchase your home may not qualify if it isn’t secured by the home. Certain rules also determine your eligibility. For instance, as already noted, you can’t deduct mortgage interest if you take the standard deduction. Instead, you must itemize your deductions. And the mortgage interest deduction isn’t a dollar-for-dollar reduction, but it depends on your tax bracket.
Mortgage Interest Deduction Example
Suppose 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.
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 at your property all that 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’re looking at higher-priced properties.
Ultimately, it all depends on your needs. If you’re ready to take the next step toward buying a home, begin your application online with Rocket Mortgage® and connect with one of our Home Loan Experts today.
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How Are Mortgage Rates Determined? A Comprehensive Look At Mortgage Interest Rates
Mortgage Basics - 7-minute read
Hanna Kielar - January 29, 2024
Crunching the numbers and wondering how mortgage rates are determined? Read our guide to learn how they’re calculated, plus how to get the best rate possible.