Back to articlesHow Does Mortgage Interest Work?
Published on: 03/21/2024
For many people, buying a home is among the biggest purchases they make in their lifetime. That’s why most homebuyers—78% according to the National Association of Realtors—rely on financing to make their home purchase possible.[1]
Whether you already own a home or your goal is to buy a new home in the future, it’s important to understand how the process works. Home loans, also known as mortgages, can span decades—commonly as long as 30 years. And interest costs over this period can add up to a significant amount.
Yet if you understand the factors that affect mortgage interest rates and the different options available, you might be able to put yourself in a better financial position. Here’s what you need to know.
What is interest on a mortgage?
When you borrow money to buy a home, the lender will expect you to repay those funds over time. However, it’s not just your loan amount (called principal) you’ll need to pay back. The lender will also expect you to pay an additional sum known as mortgage interest.
Mortgage interest is the cost of taking out a home loan. It’s how the lender earns a profit.
Each month, your mortgage lender will apply a portion of your payment toward your principal balance and a portion toward interest charges. You can check the amortization schedule in your loan documents to see how much of your payment goes toward each.
In the beginning of your loan, the majority of your payment typically goes toward interest charges. Yet as time passes, you should owe less interest. At that point, a larger portion of your payment should start to go toward your principal balance and a smaller portion should apply to your mortgage interest costs.[2]
Depending on the terms of your mortgage loan, you might be able to pay extra toward your principal balance if you desire to do so. This strategy could help you save money on interest charges and pay off your loan balance faster.
Note: If you owe money to other creditors, such as credit card companies, it’s typically best to focus on paying down those balances first. When you pay down credit card debt before you pay off a mortgage or other lower-interest debts, you could save more money in interest charges. This approach might also better your credit score thanks to the way credit card utilization impacts your credit score.
Factors that affect mortgage interest rates
When you take out a mortgage, a lower interest rate has the potential to save you thousands of dollars, often more, over the life of your loan. Therefore, qualifying for a mortgage with the lowest interest rate possible is an important goal when you buy a home.
There are numerous factors that may impact the interest rate on your home loan. Below are six details a lender may consider when it sets the terms of your mortgage, including your interest rate.
- Current interest rates: Some of the most important influences that determines the interest you’ll pay on a mortgage are factors you cannot control. Broad economic conditions including decisions the Federal Reserve makes regarding the federal funds rate (which is impacted by inflation) and effects to the bond market can all play important roles in determining the mortgage interest rates lenders offer customers.[3]
- Credit score: Your credit score is perhaps the biggest factor that you can control where your mortgage interest rate is concerned. In general, lenders reserve the best interest rates for borrowers with FICO® Scores of 760 or higher. Yet you might be able to buy a home with a minimum credit score as low as 500. However, even though an FHA loan may be possible with a 500 FICO Score, you’ll need to find a lender that’s willing to approve your loan application. You should also be prepared to pay a higher interest rate on your mortgage if you qualify.[4] [5]
- Credit history: Your credit reports from all three major credit bureaus can also influence the interest rate a lender offers you on a home loan. Your credit scores are also based on the information on your credit reports. Before you apply for a mortgage, it’s wise to check your credit reports for accuracy. If you discover any errors, you can dispute them with the appropriate credit reporting agency.
- Down payment: As a first-time homebuyer, you may be eligible to purchase a home with a smaller down payment (or perhaps no down payment at all if you’re eligible for an assistance program). However, putting down a larger down payment might be worthwhile if you can afford to do so since the size of your down payment could have an impact on your interest rate with certain mortgages.[6]
- Loan term: The length of your loan, also known as the loan term, may impact your mortgage interest rate. A mortgage with a longer term represents more risk for the lender. As a result, you’ll typically pay a higher interest rate for a 30-year mortgage compared to a 15-year mortgage. Nonetheless, you shouldn’t commit to a shorter loan term if the higher monthly payment will put you under financial stress due to the fact that you’ll be paying a higher monthly payment. You may also want to speak with a financial advisor before deciding which option is best for you, even if you can afford to take out a mortgage with a shorter term.
- Loan type: You may be eligible for different types of loan programs including conventional loans, FHA loans, VA loans, or USDA loans. The loan program you qualify for can have a meaningful impact on your mortgage interest rate.
How is mortgage interest calculated?
There are numerous ways lenders can calculate mortgage interest. And the exact formula your lender uses may vary based on the interest rate type on your loan.
The good news is that your lender is required to disclose both your annual percentage rate (APR) and how it will apply your mortgage payments in your loan documents. These details will let you know upfront exactly what to expect where mortgage interest costs are concerned.
Before you close on your home loan, the lender will provide you with an amortization schedule to review. The amortization schedule breaks down your monthly mortgage payment, including how much of your payment the lender will apply toward principal and interest each month. This section of your mortgage paperwork answers questions about how mortgage interest is calculated and applied on your specific home loan.
Below is an example of a mortgage amortization schedule for the first six months and the last six months of a 30-year fixed-rate mortgage on a $380,000 loan amount with an interest rate of 7.52%.
| Payment | Monthly Payment (No taxes or insurance) | Principal | Interest | Remaining Balance |
| Year 0, Month 1 | $2,662.22 | $280.89 | $2,381.33 | $379,719.11 |
| Year 0, Month 2 | $2,662.22 | $282.65 | $2,379.57 | $379,439.46 |
| Year 0, Month 3 | $2,662.22 | $284.42 | $2,377.80 | $379,152.04 |
| Year 0, Month 4 | $2,662.22 | $286.20 | $2,376.02 | $378,865.84 |
| Year 0, Month 5 | $2,662.22 | $288.00 | $2,374.23 | $378,577.85 |
| Year 0, Month 6 | $2,662.22 | $289.80 | $2,372.42 | $378,288.05 |
| Year 29, Month 7 | $2,662.22 | $2,564.28 | $97.94 | $13,064.47 |
| Year 29, Month 8 | $2,662.22 | $2,580.35 | $81.87 | $10,484.12 |
| Year 29, Month 9 | $2,662.22 | $2,596.52 | $65.70 | $7,887.60 |
| Year 29, Month 10 | $2,662.22 | $2,612.79 | $49.43 | $5,274.81 |
| Year 29, Month 11 | $2,662.22 | $2,629.17 | $33.06 | $2,645.64 |
| Year 29, Month 12 | $2,662.22 | $2,645.64 | $16.58 | $0.00 |
How much interest will I pay on my mortgage?
People seldom realize how much they pay in interest over a lifetime. In the case of a mortgage, it’s common for interest charges to cost more than the amount you pay to purchase your home.
There are many details that can impact how much interest you’ll pay over the course of your mortgage loan. The length of your loan plays a role in your overall interest costs, along with whether you decide to make extra payments toward your principal loan amount in an effort to save money.
Yet the biggest factor that influences your mortgage interest costs is probably your credit score range. A good credit score could easily save you tens of thousands of dollars on a mortgage.
Below is an example of how a good FICO Score might help you lock in a lower interest rate on a mortgage, and how much money you might be able to save in interest fees if it does.
Loan savings example: 30-year fixed mortgage, $380,000
| FICO Score Range | Credit Score Rating | APR Estimate | Monthly Payment | Total Interest Charges |
| 620-639 | Fair | 8.293% | $2,866 | $651,871 |
| 640-659 | Fair | 7.747% | $2,722 | $599,768 |
| 660-679 | Fair/Good | 7.317% | $2,610 | $559,442 |
| 680-699 | Good | 7.103% | $2,554 | $539,616 |
| 700-759 | Good/Very Good | 6.926% | $2,509 | $523,345 |
| 760-850 | Very Good/Exceptional | 6.704% | $2,453 | $503,103 |
In the hypothetical example above, earning a very good/exceptional FICO Score of 760 or higher could save you $413 per month and $148,768 in total interest charges over the life of the loan. This savings is compared to the price you might pay for the same loan if you applied for financing with a fair FICO Score of 620 to 639.
The interest costs above are only an example. But they demonstrate a real concept—better credit scores have the ability to save you a significant amount of money when you buy a home.
Although you might be able to buy a house with bad credit in certain situations, it might be worthwhile to work on improving your credit first due to the financial implications. At the very least, if you purchase a home with bad credit and you receive less attractive interest rates as a result, you may want to work on improving your credit for the future so that you have the option to refinance your mortgage in the future if you desire to do so.
Types of mortgage interest rates
Mortgage loans can also feature different types of interest rates. The three basic options are fixed-rate mortgages, adjustable-rate mortgages (ARMs), and interest-only mortgages.
The home loan option you choose can have a meaningful impact on your monthly payment size and overall interest costs. Below are some important details you should know about each option.
Fixed-rate mortgages
Fixed-rate mortgages are the most common and popular type of home loan. When you choose this type of mortgage, your interest rate and monthly payment amount remain the same throughout your entire loan term whether it lasts for 10 years, 15 years, or 30 years.
It’s worth noting that if you use an escrow account to have your lender collect your taxes and insurance throughout the year and pay those expenses on your behalf, your payment might fluctuate even with a fixed-rate mortgage. But it’s your escrow costs that could vary as taxes and insurance fees change, not your actual loan costs with this type of mortgage.
Adjustable-rate mortgages (ARMs)
Adjustable-rate mortgages are home loans with interest rates that are subject to change with the market. In general, these loans start out with an interest rate that’s fixed for a set period of time—often seven to ten years. Yet when that initial period ends, the lender is free to raise or lower your interest rate based on an index such as the Secured Overnight Financing Rate (SOFR).
Lenders will use special number structures to provide information about how your ARM works—including how long the initial fixed interest rate period lasts and how often it can adjust your rate thereafter. A 5/1 ARM, for example, features a five year fixed rate at the beginning of the loan after which the lender can adjust your interest rate once a year.[8]
In some cases, an ARM may help you get into a home with a lower starting interest rate and monthly payment than you might receive using a traditional fixed rate loan. But it’s important to do the math and make sure you could still afford the payments if your interest rate increases in the future before you commit to this type of loan.
Interest-only mortgages
Some mortgages may offer to let you pay only interest for the first few years of the loan term without paying any money toward your principal loan balance. This option could help you lock in a lower monthly payment, potentially helping you make homeownership more affordable in the short term. Yet there’s also risk involved with these types of loans that you should understand before you commit.
Interest-only mortgages are often set up as ARMs. After an initial period, you will no longer have the option to make interest-only payments. At that point, you’ll have to begin paying both interest and principal payments to your lenders—often increasing your monthly payment size by a sizable amount.
Furthermore, the interest rate on these loans may fluctuate as well depending on the terms of your loan. If interest rates rise, your payments could increase due to this factor as well.
People may consider an interest-only mortgage if they’re planning on selling their home after a few years. Likewise, homeowners who don’t mind trying to refinance their mortgage might be more comfortable with this type of loan. But since there are no guarantees in either of these scenarios, it’s important to take a close look at the risks associated with interest-only loans before moving forward.
Bottom line
Whether you’re already a homeowner or your goal is to purchase a home in the future, it’s wise to understand how mortgage interest works. You should also work to make sure your credit is in the best shape possible since the condition of your credit plays an important role in the interest rate a mortgage lender may offer you.
Keep in mind that it’s typically not possible to raise your credit score 100 points overnight. But there are positive steps you can take if your credit needs improvement. If you’re already paying rent, free rent reporting to build credit with all three credit bureaus might be a great place to start.
Sources
- Nar.realtor. “Home Buyers and Sellers Generational Trends Report.” https://www.nar.realtor/sites/default/files/documents/2023-home-buyers-and-sellers-generational-trends-report-03-28-2023.pdf
- Consumerfinance.gov. “How does paying down a mortgage work?” https://www.consumerfinance.gov/ask-cfpb/how-does-paying-down-a-mortgage-work-en-1943/
- Forbes.com. “Mortgage Rates Forecast for 2024: Experts Predict How Much Rates Will Drop.” https://www.forbes.com/advisor/mortgages/mortgage-interest-rates-forecast/#:~:text=Despite%20the%20recent%20surge%2C%20most,affordability%20remains%20to%20be%20seen
- myFICO.com. “Loan Savings Calculator.” https://www.myfico.com/credit-education/calculators/loan-savings-calculator/
- Quickenloans.com. “FHA Loan Credit Score Requirements: Everything to Know for 2023.” https://www.quickenloans.com/learn/fha-loan-credit-score
- Consumerfinance.gov. “Seven factors that determine your mortgage interest rate.” https://www.consumerfinance.gov/about-us/blog/7-factors-determine-your-mortgage-interest-rate/
- Quickenloans.com. “Amortization Schedule Calculator.” https://www.quickenloans.com/mortgage-amortization-calculator
- Rocketmortgage.com. “Fixed- Vs. Adjustable-Rate Mortgage (ARM): What’s the Difference?” https://www.rocketmortgage.com/learn/arm-vs-fixed
About the author
Michelle Lambright Black is a nationally recognized credit expert with two decades of experience. She is the founder of CreditWriter.com, an online credit education resource and community that helps busy moms learn how to build good credit and a strong financial plan that they can leverage to their advantage. Michelle's work has been published thousands of times by FICO, Experian, Forbes, Bankrate, MarketWatch, Parents, U.S. News & World Report, and many other outlets. You can connect with Michelle on Twitter (@MichelleLBlack) and Instagram (@CreditWriter).
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