How Interest Rates Work On a Mortgage
Buying a home with a mortgage is probably the largest financial transaction you will enter into. Typically a bank or mortgage lender will finance 80% of the price of the home, and you agree to pay it back – with interest – over a specific period. As you are comparing lenders, rates, and options, it’s helpful to understand how interest accrues each month and is paid.
How Your Monthly Mortgage Payment Is Calculated
Simply put, every month you pay back a portion of the principal (the amount you’ve borrowed) plus the interest accrued for the month. Your lender will use an amortization formula to create a payment schedule that breaks down each payment into paying off principal and interest. The length or life of your loan also determines how much you’ll pay each month.
Stretching out payments over more years (up to 30) will generally result in lower monthly payments. The longer you take to pay off your mortgage, the higher the overall purchase cost for your home will be because you’ll be paying interest for a longer period. See for yourself how changing the terms of your mortgage can change the cost of your home by using Investopedia's mortgage calculator.
Learning the Terms: Fixed Rate vs. Adjustable Rate
Banks and lenders primarily offer two types of loans:
Fixed Rate: interest rate does not change.
Here's how these work in a home mortgage:
Fixed-rate mortgage: The monthly payment remains the same for the life of this loan. The interest rate is locked in and does not change. Loans have a repayment life span of 30 years; shorter lengths of 10, 15, 20 years are also commonly available. Shorter loans will have larger monthly payments that are offset by lower interest rates and lower overall cost.
Example: A $200,000 fixed-rate mortgage for 30 years (360 monthly payments) at an annual interest rate of 4.5%, will have a monthly payment of approximately $1,013. (Taxes, insurance, escrow are additional and not included in this figure.) The annual interest rate is broken down into a monthly rate as follows: an annual rate of, say, 4.5% divided by 12 equals a monthly interest rate of 0.375%. Every month you’ll pay 0.375% interest on the amount you actually owe on the house.
Your first payment of $1,013 (1 of 360) applies $750 toward interest and $263 toward the principal. The second monthly payment, since the principal is a little smaller, will accrue a little less interest and slightly more of the principal will be paid off. By payment 359, most of the monthly payment will be applied toward principal.
Adjustable-rate mortgage (ARM): Because the interest rate is not locked in, the monthly payment for this type of loan will change over the life of the loan. Most ARMs have a limit or cap on how much the interest rate may fluctuate, as well as how often the interest rate can be changed. When the rate goes up or down, the lender recalculates your monthly payment so that you’ll make equal payments until the next rate adjustment occurs. As interest rates rise, so does your monthly payment; each payment applies to interest and principal in the same manner as a fixed-rate mortgage, over a set number of years. Lenders often offer lower interest rates for the first few years of an ARM, but then rates change frequently after that – as often as once a year.
The initial interest rate on an ARM is significantly lower than a fixed-rate mortgage.
* ARMs can be attractive if you are planning on staying in your home for only a few years.
* Consider how often the interest rate will adjust. Example: 5/1 year ARM has a fixed rate for five years, then every year the interest rate will adjust for the remainder of the loan period.
* ARMs specify how interest rates are determined – they can be tied to different financial indexes such as one-year U.S. Treasury bills. Ask your financial planner for advice on selecting an ARM with the most stable interest rate.
Example: A $200,000 5/1 adjustable-rate mortgage for 30 years (360 monthly payments) starts with an annual interest rate of 4% for five years, and then the rate is allowed to change by .25% every year. This ARM has an interest cap of 12%. Payment amount for months 1 through 60 is $955 each. Payment for 61 through 72 is $980. Payment for 73 through 84 is $1,005. (Taxes, insurance, escrow are additional and not included in these figures.) You can calculate your costs online for an ARM.
Interest-only Loans, Regular and Jumbo
A third option – usually reserved for affluent homebuyers or those with irregular incomes – is an interest-only mortgage. As the name implies, this type of loan gives you the option to pay only interest for the first few years, and it's attractive to first-time homeowners because of the low payments during their lower earning years. It may also be the right choice if you expect to own the home for a relatively short time, and intend to sell before the bigger payoff begins.
A jumbo mortgage is usually for amounts over the conforming loan limit, currently $424,100 for all states except Hawaii and Alaska, where it is higher. Additionally, in certain federally designated high-priced housing markets such as New York City, Los Angeles and the entire San Jose-San Francisco-Oakland area, the conforming loan limit is $636,150.
Interest-only jumbo loans are also available, though usually for the super-wealthy. Structured similarly to an ARM, the interest-only period lasts as long as ten years. After that, the rate adjusts annually, and payments go toward paying off principal. Payments can go up significantly at that point. (You may be interested in 5 Risky Mortgage Types To Avoid.)
Other Things To Consider
* Escrow and other fees. You’ll need to budget for other items that will significantly add to the amount of your monthly mortgage payment, such as taxes, insurance, and escrow costs. These costs are not fixed and can fluctuate. Your lender will itemize additional costs as part of your mortgage agreement.
* Should you pay a little extra each month? In theory, paying a little extra each month toward reducing principal is one way to own your home faster. Financial professionals recommend that outstanding debt such as from credit cards or student loans be paid off first, savings accounts be well-funded, and then consider paying extra each month.
*Interest is a tax deduction. If you itemize deductions on your annual tax return, the IRS allows you to deduct home mortgage interest payments; for state returns, the deduction varies. Check with a tax professional for specific advice regarding the qualifying rules. For many homeowners, this mortgage interest deduction is one of the largest write-offs they can ever take advantage of.
The Bottom Line
National policy favors home buyers via the tax code, and for many families, the right home purchase is the best way they can build an asset as their retirement nest egg. Also, if you can refrain from cash-out refinancing, the home you buy at age 30 with a 30-year fixed rate mortgage will be fully paid off by the time you reach normal retirement age, giving you a low-cost place to live when your earnings taper off. In spite of the turmoil following the financial crash of 2008 and the subsequent collapse of the housing bubble, home ownership is something you should consider in your long-term financial planning.