Everything you need to know about mortgage interest rates

Mortgage interest can add significantly to your monthly payments.  / Credit: Witthaya Prasongsin / Getty Images
Mortgage interest can add significantly to your monthly payments. / Credit: Witthaya Prasongsin / Getty Images

Interest is the cost you pay to borrow money. And though it's just one part of your monthly mortgage payments, it can often amount to significant costs over time and affect how much mortgage you can afford.

Understanding how your mortgage interest rate is calculated is a crucial step in securing a home loan. If you're shopping for a new home, you'll want to crunch the numbers to determine what you can afford. A mortgage expert can help you navigate the home-buying process and see what type of loan makes the most sense for you based on your needs.

Here's what you need to know about mortgage interest, how it is calculated and how it might impact your finances.

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Mortgage payments are comprised of two parts: Principal and interest payments.

The principal is the part of your payment that goes directly toward your balance, while the interest is the cost of borrowing the money. Your home loan balance and mortgage interest rate determine your monthly payment.

Mortgage rates can vary widely from one borrower to the next. A mortgage loan company can help you compare rates, fees and offers - just click on what you're looking for and they'll do the rest.

Mortgage lenders base interest rates on a slew of factors, including:

Credit score: Generally speaking, the higher your credit score, the better your mortgage rate. Lenders typically reserve their lowest rates for borrowers with 740 credit scores or better, documents from mortgage giant Fannie Mae show.Down payment: A larger down payment means the lender has less money on the line. Lenders typically reward a sizeable down payment with a lower interest rate. Small down payments are riskier and come with higher rates.Loan program: There are many types of mortgage loans, and some offer lower rates than others. A VA loan, for example, typically has the lowest interest rate, though they're only available to veterans, military service members and surviving spouses. With an FHA loan, you can have a lower down payment and credit score but it's only available to first-time homebuyers.Loan type: You can choose a fixed-rate mortgage or an adjustable-rate mortgage. With adjustable-rate loans, your interest rate is low initially but can rise over time. Fixed-rate mortgages usually have slightly higher rates, but they're consistent for the entire loan term.Loan term: Mortgages come in various terms - or lengths. A short-term loan tends to have a lower interest rate than a long-term home loan. For example, in 2021, the annual average interest rate on a 30-year fixed rate was 2.96%, and 2.27% on 15-year loans, according to Freddie Mac.

The economy and each mortgage lender's overhead costs, appetite for risk, and capacity will also play a role. A lender with lower overhead costs can typically offer a lower rate. These factors mean that it is essential to shop for several lenders when applying for a mortgage loan. Freddie Mac estimates that getting at least five quotes can save you up to $3,000 over the life of your loan.

How to calculate how much interest you'll pay on a mortgage

Mortgage interest is calculated in arrears - meaning for the month before your payment date. When applying for a mortgage loan, your lender should give you an amortization schedule, which breaks down just how much you'll pay in principal and interest for each month of your loan term.

At the start of your loan, more of your payment will go toward interest. You'll pay more toward your principal balance as you get further into your term.

What can cause your interest rate to change?

If you get an adjustable-rate mortgage (ARM), your interest rate and monthly payment can change.

With these loans, your interest rate is set for an initial period of three, five, seven or ten years. After that runs out, your rate rises or falls based on the market index it's tied to.

Adjustable-rate mortgage loans typically come with rate caps, limiting how much your rate can increase initially, annually and over the life of your loan. These caps can vary by lender, so it's important to compare a few different companies if you're considering an adjustable-rate mortgage.

The Federal Open Market Committee sets the short-term interest rate - the federal fund rate - that banks use to borrow money. The federal fund rate doesn't directly affect long-term rates such as mortgages, but the two tend to move in the same direction.

How to determine your monthly payment

To determine your mortgage rate and monthly payment, you'll need to get pre-approval from a mortgage lender. They will pull your credit score and ask for details regarding your finances and home purchase.

Within a few days, you'll receive a loan estimate, which will break down your estimated loan amount, mortgage rate, monthly payment and other costs that come with the loan. You can use this form to compare quotes across multiple lenders and ensure you get the best deal.

Consider mortgage refinancing

If you ultimately don't like the mortgage interest rate you receive - or decide you want to pay your mortgage down quicker than the initial 30-year time frame - then mortgage refinancing is worth considering.

This is when you take out a new loan to replace your existing one, usually at a lower interest rate and at an adjusted (shorter) length of time. Mortgage refinance rates were at historic lows in recent years. While they have edged up since the start of the pandemic they're still low enough that it could make financial sense to pursue. This could potentially save you both time and money. It's an effective way to lower your rate without doing any damage to your credit score.

Talk to a mortgage refinance expert today and see if it makes sense for you.

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