How much youll pay will depend on the type of loan you choose Part of the Series Using a Mortgage Calculator
When you buy a home with a mortgage, you dont just pay back the amount you borrowed, known as the principal. You also pay mortgage interest on the loan amount you havent yet repaid. This is the cost of borrowing money. How much you will pay in mortgage interest varies depending on factors like the type, size, and duration of your loan, as well as the size of your down payment.
Typically, a bank or mortgage lender will finance 80% or more 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, its helpful to understand how mortgages work and which kind may be best for you.
Buying a home is an exciting milestone in life, but it can also be overwhelming, especially when it comes to understanding how home loans and interest rates work. As a new homebuyer, you want to make sure you choose the right mortgage option so you can get the keys to your dream home.
In this comprehensive guide, I’ll walk you through everything you need to know about home loan interest and how it impacts your monthly payments and overall costs.
What is Interest on a Home Loan?
When you take out a home loan from a bank or mortgage lender, you are borrowing a large sum of money from them to pay for your home In return, you agree to pay back the amount you borrowed (known as the loan principal) plus additional interest over a set period of time
The interest is essentially the cost you pay to borrow money from the lender. It is calculated as a percentage of the principal loan amount. The lender charges interest so they can make a profit from lending you money.
For example, if you take out a $200,000 home loan with a 5% interest rate, you will owe $10,000 in interest charges for the first year of the loan (5% of $200,000)
The amount of interest you pay depends on your loan amount, interest rate, and loan term. It directly impacts your monthly mortgage payments. Generally, the higher the interest rate and longer the loan term, the more interest you will pay over the life of the loan.
How Home Loan Interest Rates Are Determined
Several key factors determine the interest rate lenders will offer you on a home loan:
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The Federal Reserve’s interest rates – Interest rates set by the Fed impact rates across the lending market. When the Fed raises rates, home loan rates also tend to rise.
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Your credit score and history – Borrowers with higher credit scores get lower rates since they are seen as less risky.Those with poor credit pay higher rates.
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Down payment amount – The larger your down payment, the lower your interest rate since you are borrowing less money.
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Debt-to-income ratio – Lenders look at your total monthly debts versus income. The lower this ratio, the better your rate.
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Loan type – Fixed-rate loans have higher rates than adjustable-rate mortgages (ARMs) which have introductory teaser rates.
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Loan term – Shorter loan terms (15 years versus 30 years) come with lower interest rates.
Shop around with multiple lenders to find the best possible rate for your situation. Even small differences of 0.25% in rates can impact interest costs by thousands over the loan’s duration.
How Interest Impacts Your Monthly Home Loan Payment
Your monthly mortgage payment consists of two main components:
Principal – This is the portion of your payment that goes towards repaying the amount you originally borrowed (the loan principal).
Interest – This is the additional cost you pay each month for borrowing the money. It is calculated as a percentage of your outstanding principal loan balance.
In the first years of your mortgage, you pay more in interest charges and less towards principal. But over time, as your loan balance decreases, a larger portion of your payment goes to paying down principal.
For example, on a $200,000 loan at 5% interest over 30 years:
- In year 1, your monthly payment is about $1,073
- $833 goes to interest
- $240 goes to principal
- In year 10, your payment is still $1,073
- $679 goes to interest
- $394 goes to principal
By the end of the loan, almost your entire payment goes towards principal.
Fixed-Rate vs. Adjustable-Rate Interest
There are two main types of home loans, each with different interest terms:
Fixed-rate: Your interest rate stays the same for the full loan term, such as 30 years. This means your monthly principal & interest payment is fixed.
Adjustable-rate (ARM): Your initial interest rate is fixed for a set period, such as 5 years, then adjusts periodically based on market rates. Your payment adjusts up or down too.
Fixed-rate loans offer predictable payments. ARMs start with lower rates but eventually your payment and interest costs may rise.
Choose the option that aligns with your budget and plans to live in the home. If you want rate stability, a fixed loan may be better. If you plan to move sooner, an ARM could provide short-term savings.
Factors That Impact Total Interest Paid
While your interest rate is a big factor, other elements influence your total interest costs over the full loan repayment:
Loan term – The longer you take to repay the loan, the more total interest you pay. A 30-year term accrues more interest than a 15-year term.
Loan type – ARMs have lower initial rates than fixed-rate mortgages, but over time may accrue more interest if rates rise.
Home price and down payment – The more expensive the home, and smaller your down payment, the higher your loan amount and interest charges.
Extra payments – Making additional principal payments shortens your loan and reduces total interest paid.
Refinancing – You can refinance your loan at a lower rate to reduce interest expenses if rates drop.
Carefully consider these factors as you choose your mortgage to optimize for lower long-term interest costs.
Common Questions About Home Loan Interest
If you’re still unsure how interest works, here are answers to some common questions:
Why is interest charged on home loans?
Interest is the way lenders earn profit for providing loans. They take on risk by lending large sums, so charge interest to compensate.
Why do rates vary by lender?
Each lender has different criteria for determining risk and pricing loans accordingly through interest rates offered. Shop around for the best rate.
Why is my mortgage payment mostly interest initially?
In the early years of a loan, you have a large principal balance so owe more in interest each month. Over time as the principal declines, more of your payment goes to principal.
Can I ever pay zero interest on a home loan?
Most lenders require interest charges. But in some cases, like a privately financed home sale, the seller may not charge interest if you know them well.
Should I get a fixed or adjustable rate mortgage?
Fixed rates offer stability while ARMs start lower but carry risk of increasing payments when rates adjust. Choose based on your budget, plans to stay in the home, and risk tolerance.
The Bottom Line
Understanding how home loan interest works is key to choosing the right mortgage product with affordable payments. Be sure to consider the interest rate, loan type, term, your down payment, and other costs when applying for a home loan.
What Interest Rate Will I Get When I Take out a Mortgage?
The interest rate you get on your mortgage depends on a variety of factors. The economic climate and interest rates set by the Federal Reserve impact mortgage rates, as do other things.
From there, lenders will calculate your interest rate based on your financial situation, including your credit score, any other debts you have, and your likelihood of defaulting on a loan. The less risky a lender thinks it is to lend your money, the lower your interest rate will be.
Fixed-Rate Interest vs. Adjustable-Rate Interest
Lenders set your interest rate based on various factors that reflect how risky they think it is to loan you money. For example, you will likely be offered a higher interest rate if you have a lot of other debt, an irregular income, or a low credit score. This means that the cost of borrowing money to buy a house is higher.
You are more likely to be offered a lower interest rate if you have a high credit score, few or no other debts, and reliable income. This means that the overall cost of your mortgage will be lower.
Your mortgage interest rate is also impacted by the type of mortgage you get. Banks and lenders primarily offer two basic types of loans:
- Fixed-rate: The interest rate is set when you take out the mortgage and does not change.
- Adjustable rate: The interest rate you start with will change under defined conditions (also called a variable rate or hybrid loan).
Here’s how the two types work.