Understanding how mortgage interest rates work empowers you to better navigate your financial goals. Mortgage rates include the interest charged by your lender. Knowing the different types of mortgages as well as the external and personal factors that impact rates can place you in a stronger financial position when heading into the future.
What Is Mortgage Interest?
Mortgage interest is the interest charged when buying property such as a house, condo or apartment. A mortgage interest rate is a fee or charge linked with borrowing from a mortgage lender. Interest is paid on the outstanding portion of the loan.
Why You Have to Pay Interest On Mortgage Loans
You pay interest on mortgage loans when you pay back the lender that provided you with the funds. Lenders run a service business, and interest charges – coupled with other fees – help cover the costs and risks associated with lending. Additional monthly charges can include taxes and insurance fees.
How Mortgage Interest Rates Are Calculated
Mortgage rates are calculated using a wide range of factors such as the amount of your loan, your credit history, your debt and the amount of perceived risk a lender is taking on by lending to you. Mortgage interest evaluates the cost associated with borrowing or taking out a loan. The rate is calculated as a portion of the monthly payment.
When first making payments, it’s typical to pay more on interest compared to the principal. Once the outstanding amount of the loan decreases, less of your monthly payment will go toward interest and more will work toward paying off the principal.
Top lenders provide tools such as mortgage calculators to guide you through the process of calculating a loan. An automated calculating tool offers insight into future loan payments.
How Interest Works for Different Types of Mortgages
Not all mortgages are created equal. When exploring the available mortgages on the market, examine how interest rates work with each type of home loan. Mortgages range from fixed-rate to adjustable-rate and interest-only; read more here to discover your perfect fit.
Fixed-Rate Mortgages
Fixed-rate mortgages use a fixed or set interest rate for the duration of the loan. The rate does not change and will likely make it easier for you to predict future payments. Fixed interest can be calculated using the amount and total term of the loan. The lender charges a set rate during the term of a fixed-rate mortgage, resulting in consistent payments throughout the loan.
Adjustable-Rate Mortgages (ARMs)
Adjustable-rate mortgages (ARMs) function using interest rates that can change. Because interest rates are not fixed, the monthly payments tend to fluctuate over time. According to the U.S. Department of Housing and Urban Development (HUD), the initial interest rate of an ARM is usually lower than the interest rate charged by a fixed-rate mortgage. For example, an ARM might be beneficial if you do not intend to own your home for an extended period.
Interest-Only Mortgages
Interest-only mortgages (IO mortgages) allow you to focus on paying off the interest at the start of the loan. In the beginning, monthly payments are lower for homebuyers because you will mostly focus on paying off the interest. After the initial period, you will begin paying off the principal and the interest. It’s common for interest-only mortgages to be able to be structured as adjustable-rate mortgages where monthly payments will likely increase after the initial interest-only period.
Jumbo Mortgage Loans
A jumbo mortgage loan covers properties that are above the loan limitations set by government-backed housing agencies. The loan offers larger loan amounts while using stricter guidelines. For example, to qualify for a jumbo mortgage loan, you will likely need a stronger credit score and face stricter down payment requirements.
Factors That Affect Mortgage Rates
Before entering into a mortgage, examine the external and personal factors that impact mortgage rates. Personal factors such as your credit score, your income and your debt-to-income ratio will impact your mortgage rate.
External Economic Factors
When navigating mortgage interest rates, research the external economic factors that impact your rates. Before taking a loan, understand the larger market, inflation trends and current government policies.
Market Conditions
Market conditions affect the direction of interest rates. For example, when market conditions are positive or bullish, mortgage rates may increase.
Inflation
Although inflation influences market rates because it impacts demand, it doesn’t directly impact mortgage rates.
Government Policy
Government policy indirectly sways mortgage interest rates. The Federal Reserve impacts mortgage rates by crafting monetary policies and determining the federal funds rate. The Federal Open Market Committee (FOMC) influences monetary policies to achieve larger economic goals.
Personal Financial Factors
Personal finance factors will potentially impact your mortgage interest rates. Key areas include your credit score, income and debt-to-income ratio, each of which affects mortgage rates.
Credit Score
Your credit score impacts your mortgage rate. Before taking out a mortgage, review your credit score using one of the many reputable free services. Higher credit scores – above 670 – get you the lowest interest rates.
Income
Your income will likely play a role in your ability to receive a favorable mortgage interest rate. For example, it’s recommended to spend less than 28% of your gross income on your mortgage. Lenders recognize that spending less income on a mortgage frees up finances, helps borrowers better navigate unexpected expenses and reduces loan defaults.
Debt-to-Income Ratio
The debt-to-income ratio recommends a ratio below 43% in most situations. The ratio indicates that less than 43% of your monthly income should be spent on your total debt. Having a lower debt-to-income ratio will likely qualify you for a more favorable mortgage.
How to Get a Lower Mortgage Rate
Getting a lower mortgage rate requires a combination of steps that examine and anticipate multiple personal and external factors. When attempting to get a lower rate, explore the different types of mortgages to decide which one works best for you. Refinancing or putting down a larger down payment may lower your rate. Review how personal and external factors can play a role in your ability to receive a favorable rate. For example, having a strong credit score and a low debt-to-income ratio will likely place you in a more favorable position as you navigate the mortgage process.
How to Lock in Your Mortgage Rate
The mortgage rate locking period extends from the time your loan is approved to the time that it closes. Locking in your mortgage rate ensures that the rate won’t change for a set amount of time. Speak with several lenders to understand their individual processes. Keep in mind that locking in a rate usually does not bind you to work with a specific lender. Have documents on hand such as your credit report and proof of identification to help expedite the process. Before locking in a rate, ask your lender questions regarding its rate-lock policy and the possible benefits and drawbacks related to locking in a rate.
How to Change Your Existing Mortgage Rate
With the right steps, you could change your existing mortgage rate. Shop for a better rate to understand the current mortgage market. Take advantage of local, state, federal or military loan programs. Consider changing your loan term or lowering your principal balance. Speak with a lender to better understand the options available to you.
Lock in a Better Future with a Favorable Mortgage Rate
Finding the right mortgage rate could put you one step closer on your journey to becoming a homebuyer. Compare the various types of mortgages to know what opportunities would best fit your needs. With the right team, selecting the best mortgage while achieving a lower mortgage rate may send you sprinting to the financial finish line.
Frequently Asked Questions
Is mortgage interest compounded monthly or yearly?
Mortgage interest is accrued monthly. Some mortgages may be compounded daily.
Why is your mortgage interest different every month?
The mortgage interest tends to differ every month depending on factors such as the total number of days in the month and the interest rate.
Why is it better to have a lower interest rate on my mortgage?
A lower interest rate helps to create lower mortgage payments and results in less money paid over the life of the loan. Lower rates allow you to save more money.
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