How Do Mortgage Interest Rates Work?

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Contributor, Benzinga
May 30, 2023

Mortgage interest rates are the amount you pay in interest on the mortgage principle. Mortgage lenders will typically lend 70% to 100% of the mortgage value, with the understanding that you'll pay for the convenience of the loan through interest. How do mortgage interest rates work? The higher the mortgage interest rate, the more you'll pay long term. 

What is mortgage interest? It's the amount you'll pay on a loan's principal each year over the loan's lifetime. The best mortgage interest rate depends on the loan amount, duration, mortgage type and market conditions.  If you're wondering how mortgage interest rates work, below you'll find a breakdown of mortgage interest rates explained and tips to get the best interest rate. 

What Are Mortgage Interest Rates?

Mortgage interest rates are expressed by APR, or annual percentage rate. APR is the yearly interest charged to borrowers on a loan amount. APR is expressed as a percentage representing the yearly cost of funds over a loan term. For example, an APR of 5% would mean you'll pay 5% per year on the loan's principal.  

Mortgage APRs can be fixed or variable. For fixed rates, you will have the same interest rate for the duration of the mortgage. Fixed-rate mortgages range from 4.75% to 7% or more, depending on loan duration, amount and the borrower's financial profile.

Variable rate mortgages, as the name implies, change over time. While you may initially get a lower interest rate, this could rise over time and lead to higher mortgage payments.  

Factors Influencing Mortgage Interest Rates

Mortgage interest rates are constantly in flux. These are the top 3 factors that will influence your mortgage rate at any time.

Economic Factors 

Economic factors across the U.S. and globally, such as inflation, real estate market trends and market factors, can affect interest rates. Supply and demand and inflation are the two biggest market factors that push or pull interest rates. 

When the inflation rate rises, interest rates often rise because lenders demand higher interest rates as compensation for the decrease in purchasing power of the future money they are paid back for the loan.

Supply and demand function similarly. An increase in the demand for money or credit will raise interest rates, while a decrease in the demand for credit will decrease interest rates.

Role of the Federal Reserve

While the Federal Reserve doesn't directly set interest rates, announcements it makes about monetary policy affect interest rates. The Fed also influences interest rates by buying or selling previously issued U.S. securities. 

When the government buys more securities, banks receive more money that they can use for lending, leading to decreased interest rates. On the other hand, when the government sells securities, the banks have fewer funds at their disposal, increasing interest rates.

Your Finances

Within the larger economic climate, your finances will have the largest impact on your mortgage interest rate. Lenders will examine your credit score, debt-to-income ratio, loan-to-value ratio and down payment amount. 

Your debt-to-income ratio is the ratio of total debt, including student loans, car payments, credit card debt and mortgage or rent payments, to income. A higher debt-to-income ratio is a higher risk for lenders. 

The loan-to-value ratio is the ratio of the mortgage amount to the appraised property value. A high loan-to-value ratio is generally considered a higher risk to lenders. 

You can check your credit score on https://www.annualcreditreport.com/ and aim for a credit score of more than 700 or 740 for lower interest rates. You can also save for a larger down payment to lower interest rates. 

3 Types of Mortgage Interest Rates

You can consider three types of mortgages. All have pros and cons. Here's how these mortgage rates work.

1. Fixed-Rate Mortgages

Fixed-rate mortgages have a set interest rate for the duration of the loan. The advantage is your monthly payment won't change over the duration of the loan. The disadvantage is you may be locked into a higher interest rate if you didn't secure a low-interest rate with mortgage approval. 

2. Adjustable-Rate Mortgages (ARMs)

Adjustable-rate mortgages (ARMs) are also called variable-rate mortgages or floating mortgages. ARMs are reset based on a benchmark or index. Usually, ARMs use the secured overnight financing rate (SOFR) to set interest rates. 

The advantage of an ARM is that you may secure a lower interest rate initially. Many ARMs have a limit on how much the interest rate or payments can rise over the lifetime of the loan. This provides a payment cap and gives borrowers greater security.  

3. Hybrid Mortgages

Hybrid mortgages have an initial fixed-rate period followed by adjustable rates. Hybrid mortgages will show the time that the fixed rate is set for, followed by the duration of adjustments and frequency of the variable rate. The advantage of a hybrid mortgage is that you may lock in a very low-interest rate for the first one to two years of the loan. 

How Mortgage Interest Rates Impact Your Loan

With how mortgage rates work, interest rates have a major impact on mortgage payments over the loan's lifetime, leading to thousands more (or less) in interest. On a $400,000 loan, each 1% increase in interest rate equals more than $95,000 in additional interest payments over a 30-year loan. Here's an example:

Suppose you are taking out a $400,000 mortgage. Lender A offers you 7% interest on a 30-year mortgage. Lender B offers you 6% interest on a 30-year mortgage. 

At 6% interest from Lender B, you'll pay $463,483 in interest over the lifetime of the loan, that's more than the total principal of the loan. At 7% interest from Lender A, you'll pay $558,216 in interest, nearly $100,000 more.  

On the other hand, suppose Lender C offers 4% interest. In that case, you'll pay only $287,699 over the loan's lifetime in interest. If you maintain the 4% interest rate and reduce the loan duration to 15 years, you'll pay $132,625 in interest, less than half of what you'd pay in 30 years. 

Tips for Getting the Best Mortgage Interest Rate

Securing the best mortgage interest rate is crucial for saving money over the life of your loan. Here are some tips to help you get the best mortgage interest rate possible.

Factors Lenders Consider When Setting Interest Rates

Lenders will be more willing to offer good interest rates if you have a higher down payment or a lower debt-to-income ratio. A high credit score, stable employment and significant savings or investment accounts can also help you secure a lower interest rate. 

Ways to Improve Your Credit Score to Get Lower Interest Rates

Improving your credit score requires consistency. To improve your credit score:

  • Pay all bills on time: Even a single late payment can affect your credit score. Set up auto payments for utility bills and credit cards to ensure you never miss a payment.
  • Pay off debt: Lowering total debt can improve your credit score.
  • Don't open new accounts: Opening a new account may cause a temporary dip in your credit score. 
  • Get credit for bill payments: Paying utilities and rent on time can boost your credit score. You can do this with a rent reporting company. 
  • Become an authorized user: If you have a friend or family member with a high credit score, becoming an authorized user on their credit account can boost your score. 
  • Ask for a credit line increase: This won't hurt your credit score but can lower your total debt and the percentage of available credit used, boosting your credit score. 

The Benefits of Shopping Around for the Best Mortgage Interest Rate

Of course, you'll only need one mortgage approval. That means that you should shop around to find the best mortgage rate. After you've done everything possible to boost your credit score and pay off debt, you can still find more competitive rates by applying to five to 10 mortgage lenders within a couple of weeks. Don't wait too long between mortgage applications, or it could cause a dip in your credit score. Learn more about how to choose the best mortgage lender

More Advice on How Mortgage Interest Works

Two types of factors affect mortgage interest rates — those you can control and those you can't. While you can't affect larger market factors, you can build up your savings, pay off debt and improve your credit score so you're poised to take advantage of the best mortgage rates when the larger market is most favorable. Find the current best 15-year mortgage rates and 30-year mortgage rates to get started. If you've already got a mortgage with a high-interest rate, you can find the best mortgage refinance options. 

Frequently Asked Questions

Can I negotiate my mortgage interest rate?

Yes, you can negotiate mortgage interest rates with the mortgage lender. It helps to have more than one offer to strengthen your position.

How is the interest rate for my mortgage determined?

Market factors, including the Federal Reserve, bond market, secured overnight finance rate and constant maturity Treasury, along with inflation and the health of the economy, affect mortgage rates. Your personal financial situation, including debt-to-income ratio, credit score, savings, and downpayment, all affect your final mortgage rate.

What happens if interest rates change after I sign my mortgage?

Your interest rates will remain stable if you've already closed on the home. But if you've been preapproved for a mortgage and haven't yet closed on a home, your interest rates may change when you close.

About Alison Plaut

Alison Plaut is a personal finance writer with a sustainable MBA, passionate about helping people learn more about financial basics for wealth building and financial freedom. She has more than 17 years of writing experience, focused on real estate and mortgage, business, personal finance, and investing. Her work has been published in The Motley Fool, MoneyLion, and she is a regular contributor for Benzinga.