How Does Mortgage Interest Work?
Mortgage interest rates are a crucial determinant of whether a renter leaps homeownership. Lenders will typically finance up to 80% of the buying price. It is important to understand how mortgage interest works and what goes into your monthly mortgage payments before you sign up.
How Does Mortgage Interest Work
Mortgages are calculated based on two factors:
- The type of loan
- The repayment period
The total monthly amount that you pay may have other payments tacked onto it such as:
- Real estate tax
- Private mortgage insurance
- Homeowner’s insurance
Types of Mortgage Loans
A fixed-rate mortgage is one where the interest rate is locked for the entire repayment period. Your monthly repayments are also fixed throughout.
This type of loan typically has a long lifespan of 30 years. Shorter repayment periods of 10, 15, or 20 years are available at a lower interest percentage but higher monthly repayments.
Example: A $300,000 mortgage for 30 years at an annual interest rate of 3.42% following a 20% down payment breaks down as follows:
- Monthly repayment for 30 years (360 months) – $1,577.85
- Total mortgage size (principal) – $240,000
- Total mortgage interest – $144,126.57
- The monthly $1,577.85 = $ 1,067.02 (principal & interest) + $ 400.00 (property tax) + $ 110.83 (Homeowners Insurance)
In the beginning, about 75% of your loan repayment is applied to the interest while 25% goes to the principal. As your interest accrued diminishes, more and more of your monthly fee is applied to the principal loan amount. This is called building equity.
Eventually, by your last payments, the whole monthly fee will be applied to paying off the principal.
A mortgage calculator will help paint a financial picture for you in the coming years.
One financial tip for decreasing your interest rates over time is to apply lump-sum payments to the principal of the mortgage loan. A smaller principal equals less interest.
Think end-of-year bonuses, tax refunds, and other auxiliary money coming in. Or you can add the lump sum to your monthly savings budget. If you need help saving money, here’s a short beginner’s guide on how to save money.
The primary benefit of fixed-rate mortgages is predictability. You know how much you will pay monthly for the next 30 years. You’re protected from interest rate fluctuations.
Longer repayment periods allow you to have the lowest monthly payments but cost more overall because you pay more interest.
Shorter payment periods have lower interest rates but the monthly burden on your budget is much higher. Our experts are available for a free consultation.
In this type of loan, the interest rate is variable. The lender will usually start you off on an initial interest rate that is lower than that of a comparable fixed-rate loan.
As the repayment period progresses, the interest rate slowly increases. If left long enough, the interest rate may eventually surpass that of fixed-rate loans.
Some of the considerations and terms to keep in mind for adjustable-rate mortgages (ARM) are:
- Adjustment Frequency is the period between interest rate increments and is usually pre-arranged.
- Adjustment Indexes are the benchmark on which your interest rate adjustment is based. The benchmark could be the treasury bill interest rate.
- Margin is the amount above the adjustment index you agree to pay for your mortgage interest rate.
- Caps refer to the limit on how much the adjustment is raised per period. In the case of a negatively amortizing loan, it is a cap on your total monthly payment.
- The ceiling is the highest amount your interest rate is allowed to reach during the lifetime of the loan.
Please note that in the case of negatively amortizing loans, the cap only applies to a portion of the interest. If the interest is left to accrue, it becomes a part of the principal resulting in a higher owed sum than what was borrowed.
Example: A 5/1 hybrid ARM starts with five years on a fixed interest rate. Thereafter, the interest rate rises according to the capped limit per period until you finish paying off the loan or the interest rate reaches the ceiling. Here is a breakdown:
- A $200,000 loan for 30 years will be charged at 4% for the first five years
- Monthly repayment for the first 60 months is $955
- The next 12 months’ rate goes up by 0.25% to $980 then $1055 in the following year and so on.
- These amounts don’t include insurance and taxes.
The main benefits of ARMs are:
- They are cheaper than fixed-rate loans in the short term up to seven years.
- The borrower will qualify for a bigger loan due to lower initial payments
- In a falling-interest market, the borrower enjoys lower interests and repayments without refinancing the mortgage
The major downside of ARMs is the fluctuating monthly payment which will be a significant burden for large loans or if the interest rate doubles.
Interest-Only Loans and Jumbo Mortgage Loans
These third and fourth loan options are mainly geared towards wealthy homeowners.
Interest-only loans allow your monthly payments to be applied only to the interest for the first few years. The monthly payments will be lower but you will not be building equity. This type of loan is best for the homeowner who expects to sell soon and move on.
Jumbo mortgage loans are those where the loan amount is higher than the conforming loan limit set by the Federal Housing Finance Agency. The US national baseline in 2021 is $548,250. In certain parts like New York, San Francisco, Hawaii, and Alaska, the limit goes up by 150%.
Jumbo mortgages will be fixed-rate, adjustable-rate, or interest-only. In all cases, the interest rates tend to be higher.
Even with a great interest rate, other costs associated with being a homeowner will bump up your monthly repayment.
Real-estate taxes and homeowner’s insurance are sometimes included by lenders in the mortgage payment. The money is held in escrow for the lender to pay the bills as they arise.
Homeowner’s Association (HOA) fees will also be quite steep depending on the property location and type.
The type of mortgage you choose depends on how much you will pay monthly and how long you intend to live in the house. The interest rate forecast trends matter and whether you have sufficient cushion to finance ARMs.
Your main aim is to get an interest rate that is great for your pocket and will bring you closer to your financial goal of being a homeowner. Interest rates are determined based on the interest rate set by the Fed and your credit score. See how your credit score will affect your interest rates!
Frequently Asked Questions
Why can’t mortgage interests be deducted?
In a personal loan if the loan is not a secured debt on your home, and the interest you pay usually isn’t deductible. Your home mortgage must be secured by your main home. You can’t deduct interest on another home.
What is a loan modification?
If you’ve sustained a reduction in income resulting from the crisis, then have a look at a loan modification, that might suit your new circumstances. Those changes will aim to reduce your original monthly payment amount. A previous modification or deferment won’t disqualify you from current or future eligibility for a loan modification.