Buying a home with a mortgage is the largest financial transaction most of us 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 compare lenders, mortgage rates, and loan options, it’s helpful to understand how mortgages work and which kind may be best for you.

Key Takeaways

  • Mortgages can be the biggest financial transaction most people will ever make.
  • Two basic types of mortgages are fixed and adjustable-rate loans.
  • The interest rate on your mortgage will depend on such factors as the type of loan and how long a loan term (such as 20 or 30 years) you sign up for.

How Mortgage Payments Are Calculated

With most mortgages, you pay back a portion of the amount you borrowed (the principal) plus interest every month. Your lender will use an amortization formula to create a payment schedule that breaks down each payment into principal and interest.

If you make payments according to the loan's amortization schedule, the loan will be fully paid off by the end of its set term, such as 30 years. If the mortgage is a fixed-rate loan, each payment will be an equal dollar amount. If the mortgage is an adjustable-rate loan, the payment will change periodically as the interest rate on the loan changes.

The term, or length, of your loan, also determines how much you’ll pay each month. The longer the term, the lower your monthly payments will typically be. The tradeoff is that 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.

Fixed-Rate vs. Adjustable-Rate Mortgages

Banks and lenders primarily offer two basic types of loans: 

  • Fixed Rate: The interest rate does not change.
  • Adjustable Rate: The interest rate will change under defined conditions (also called a variable-rate or hybrid loan).

Here’s how the two types work.

Fixed-Rate Mortgages

With this type of mortgage, the interest rate is locked in for the life of the loan and does not change. The monthly payment also remains the same for the life of loan. Loans often have a repayment life span of 30 years, although shorter lengths, of 10, 15, or 20 years, are also widely available. Shorter loans have larger monthly payments but lower total interest costs.

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. (Real-estate taxes, private mortgage insurance, and homeowners insurance are additional and not included in this figure.) The 4.5% annual interest rate translates into a monthly interest rate of 0.375% (4.5% divided by 12). So each month you’ll pay 0.375% interest on your outstanding loan balance.

When you make your first payment of $1,013, the bank will apply $750 to the loan's interest and $263 to the principal. The second monthly payment, as the principal is a little smaller, will accrue a little less interest, so slightly more of the principal will be paid off. By payment 359 almost all of the monthly payment will be applied to the principal.

Adjustable-Rate Mortgages (ARMs)

Because the interest rate on an adjustable-rate mortgage is not permanently locked in, the monthly payment will change over the life of the loan. Most ARMs have limits or caps on how much the interest rate can fluctuate, how often it can be changed, and how high it can go. When the rate goes up or down, the lender recalculates your monthly payment, which will then remain stable until the next rate adjustment occurs.

As with a fixed-rate mortgage, when the lender receives your monthly payment, it will apply a portion to interest and another portion to principal.

Lenders often offer lower interest rates for the first few years of an ARM, sometimes called a teaser rate, but rates can change after that– as often as once a year. The initial interest rate on an ARM tends to be significantly lower than that on a fixed-rate mortgage. For that reason, ARMs can be attractive if you are planning to stay in your home for only a few years.

If you're considering an ARM, find out how its interest rate is determined; many are tired to a certain index, such as the rate on one-year U.S. Treasury bills, plus a certain additional percentage, or margin. Also ask how often the interest rate will adjust. For example, a five-to-one-year ARM has a fixed rate for five years. After that, the interest rate will adjust each year for the remainder of the loan period.

Example: A $200,000 five-to-one-year adjustable-rate mortgage for 30 years (360 monthly payments) might start with an annual interest rate of 4% for five years, after which the rate is allowed to change by as much as 0.25% every year. The payment amount for months 1 through 60 would be $955 per month. If it then rises by 0.25%, the payment for months 61 through 72 would be $980, and the payment for months 73 through 84 would be $1,005. (Again, taxes and insurance and not included in these figures.)

Interest-Only Loans

A much rarer third option—usually reserved for wealthy home buyers 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, resulting in lower monthly payments. It might be a reasonable choice if you expect to own the home for a relatively short time and intend to sell before the bigger monthly payments begin. However, you won't build any equity in the home, and if your home declines in value, you could end up owing more than it is worth.

Jumbo Mortgage Loans

A jumbo mortgage is usually for amounts over the conforming loan limit, currently $548,250 for all states except Hawaii and Alaska, where it is higher. The limit is also higher in certain federally designated high-priced housing markets, such as New York City and San Francisco. The current maximum conforming loan limit is $822,375.

Jumbo loans can be either fixed or adjustable. The interest rates on them tend to be slightly higher than those on smaller loans of the same type.

Interest-only jumbo loans are also available, though usually for the very wealthy. They are structured similarly to an ARM and the interest-only period lasts as long as 10 years. After that, the rate adjusts annually and payments go toward paying off the principal. Payments can go up significantly at that point. 

Even with a fixed-rate mortgage, your monthly payment can change if it also includes taxes or insurance.

Don't Forget Taxes, Insurance, and Other Costs

If you're buying a home, you'll also need to consider some other items that can significantly add to your monthly mortgage payment, even if you manage to get a great interest rate on the loan itself. For example, your lender may require that you pay for your real-estate taxes and insurance as part of your mortgage payment. The money will go into an escrow account, and your lender will pay the bills as they come due. These costs are not fixed and can rise over time. Your lender will itemize any additional costs as part of your mortgage agreement and recalculate them periodically.