How Do Mortgage Interest Rates Work • Benzinga

Mortgage interest rates are the costs homeowners pay to borrow money for buying homes and they can be fixed or adjustable. 

You’ll often hear people talk about mortgage interest rates during the house hunting process. If you’re a first-time home buyer, you might be asking, how do mortgage interest rates work? That’s the question we’re here to answer. 

Our writers are homeowners who have bought properties in some of the most challenging real estate markets. On top of that, we spoke with Jason Lerner, a 22-year veteran of the mortgage industry, to understand how people can get the best mortgage interest rate for their needs. 

Read on to find out how mortgage interest rates work, the factors that affect them and the different types of rates available to prospective homeowners.  

What is a Mortgage Interest Rate?

A mortgage interest rate is a percentage charged on your home loan when borrowing money from a lender. The interest is part of your monthly mortgage payments, along with your principal balance (or the amount of money you were approved to borrow). Interest is one of the ways lenders make money when providing mortgages. 

Mortgage interest rates vary based on your financial situation, the real estate market, the mortgage type you’re applying for and the size of your loan. 

How Do Mortgage Interest Rates Work?

When you start paying your mortgage, most of your payment will go to the interest rather than the principal balance. As you continue paying it off, more money will go toward the principal and the amount of interest you pay will decrease (remember that it’s a percentage of the remaining loan balance). 

Factors that Affect Mortgage Rates

Several factors impact your mortgage interest rate. 

Principal

Your mortgage principal is the money you borrowed to buy your home. A portion of your monthly mortgage payment reduces the total principal that you owe. The amount you pay in interest each month depends on your principal balance. 

Term/Length

Your monthly mortgage payment is affected by the length of your loan. The more time you have to pay off your mortgage, the lower your payments will be. So, if you take out a 30-year mortgage, your monthly payments will be less than if you entered a 15-year mortgage. 

Credit Score 

Your credit score reflects how likely you are to repay debt and your creditworthiness could be the difference between paying a high or low mortgage interest rate. People with great credit, 700 or above, are likely to get lower interest rates because they’ve demonstrated that they’re not a risk for lenders. Those with lower scores are likely to be stuck with higher rates because they’re at a greater risk of defaulting on the loan. 

Lerner, however, says there are some cases in which waiting to improve your credit may not be the best strategy. “Even with a better credit score, if interest rates have increased you still might get stuck making larger payments,” he says. 

A good lender, he adds, will be able to find the best deal for your current score. 

Federal Reserve 

Most banks or lenders base their interest rates on the federal funds rate set by the Federal Reserve. If the Fed increases their numbers, lenders are likely to increase their rate. Likewise, if the economy improves and the Fed decreases rates you could see a drop in mortgage interest rates nationwide, though individual factors like those listed above will still come into play. 

Different Types of Interest Rates

Just as there are different types of homes and home mortgages, there are also a variety of interest rates available to homeowners.  

Fixed-Rate Mortgages

With a fixed-rate mortgage, your interest rate remains the same over the life of the loan. Not only will your interest rate remain the same, but your monthly payment will also stay the same. Fixed-rate mortgages offer stability and protection against rising interest rates. 

Adjustable-Rate Mortgages (ARMs)

An adjustable-rate mortgage (ARM) has an interest rate that can change over time. Many times, an ARM begins with a low introductory rate. Once you pass the introductory period, your interest rate could rise or fall. As your mortgage interest rate changes under an ARM, so does your monthly payment.

An ARM may be a good option if you sell your home or refinance in a few years. This is one of the key factors to consider when debating between a fixed-rate mortgage or an adjustable rate, Lerner says. 

“If they’re going to have this mortgage for less time than the loan term, an ARM might not make sense,” he says. 

Additionally, an ARM is only beneficial if the Fed drops rates significantly. “A quarter-percent or a half-percent decrease won’t decrease your payments as much as you hoped,” Lerner adds. 

Interest-Only Mortgages

With an interest-only mortgage, you make payments toward the interest owed only. Since your monthly payment doesn’t include principal, your payments are typically lower than a traditional mortgage.

The Bottom Line 

• Mortgage interest is your cost of borrowing money to buy a house.
• You calculate mortgage interest as a percentage of the principal you haven’t repaid.
• Your credit history, down payment and other factors affect your mortgage interest rate.

Why You Should Trust Us

Benzinga has offered investment and mortgage advice to more than one million people. Our experts include financial professionals and homeowners, such as Anthony O’Reilly, the writer of this piece. Anthony is a former journalist who’s won awards for his coverage of the New York City economy. He’s navigated tricky real estate markets in New York, Northern Virginia and North Carolina.

For this story, we worked with Jason Lerner, an area manager for First Home Mortgage and a 22-year mortgage industry veteran.  

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