When you purchase a home with a mortgage, you do not simply repay the amount borrowed, known as the main.
You also pay mortgage interest on the loan amount that has yet to be repaid. This is the cost of borrowing money.
The amount you pay in mortgage interest depends on the kind, 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 purchase price, and you agree to repay it with interest over a set length of time.
As you evaluate lenders, mortgage rates, and loan options, it’s important to understand how mortgages work and which type is ideal for you.
Mortgage Interest vs. Principal
Each mortgage payment will be in two parts. The principal is the amount you have borrowed but have not yet paid back. Interest is the expense of borrowing money. The mortgage interest is computed as a proportion of the remaining principal.
Most mortgages require you to pay back a portion of the amount borrowed (the principal) plus interest each month.
Your lender will use an amortization calculation to generate a payment schedule that separates each monthly payment into principal and interest.
When you first start making mortgage payments, you are likely to pay more in interest than in principal.
However, as you make payments, the amount you haven’t paid diminishes.
This means that the interest you pay each month will reduce, allowing a larger portion of your mortgage payment to be used to repay the principal.
If you pay according to the loan’s amortization schedule, the loan will be entirely paid off by the end of its specified period, which is typically 30 years.
If the mortgage is fixed-rate, each payment will be the same monetary amount. If the mortgage is adjustable, the payment will vary when the loan’s interest rate changes.
Fixed-Rate Interest vs. Adjustable-Rate Interest
Lenders determine your interest rate based on a variety of factors that reflect how dangerous they believe it is to lend you money.
If you have a lot of other debt, an unpredictable income, or a low credit score, you are more likely to be offered a higher interest rate. This means that the cost of borrowing money to buy a house has increased.
You are more likely to be provided a lower interest rate if you have a strong credit score, few or no previous loans, and a steady income. This means that the total cost of your mortgage will be reduced.
Your mortgage interest rate is also affected by the type of mortgage you obtain.
Banks and lenders primarily provide two types of loans:
Fixed-rate: The interest rate is determined when you take out the mortgage and does not alter.
Adjustable rate: The initial interest rate will alter under certain situations (also known as variable rate or hybrid loan).
Here is how the two types operate.
1. Fixed-rate mortgages.
This form of mortgage has a fixed interest rate that does not alter over the life of the loan. The monthly payment remains constant during the term of the loan.
Loans are typically repayable over 30 years; however, shorter terms of 10, 15, or 20 years are also available.
Shorter loans require higher monthly payments but have lower overall interest expenses.
2. Adjustable-Rate Mortgages (ARMs)
Because the interest rate on an adjustable-rate mortgage is not permanently fixed, the monthly payment will fluctuate throughout the loan.
Most ARMs have limits or caps on how much the interest rate can fluctuate, how frequently it can be altered, and how high it can rise.
When the rate rises or falls, the lender recalculates your monthly payment, which remains constant until the next rate adjustment happens.
When the lender receives your monthly payment, it applies a portion to interest and another to principal, just like in a fixed-rate mortgage.
Lenders frequently provide reduced interest rates for the first few years of an ARM, which are known as teaser rates, although these can fluctuate as frequently as once a year thereafter.
An ARM often has a much lower beginning interest rate than a fixed-rate mortgage. As a result, ARMs can be appealing if you intend to stay in your house for only a few years.
If you’re thinking about getting an ARM, find out how the interest rate is calculated; many are related to a specific index, such as the rate on one-year US Treasury notes, plus a specified percentage or margin.
Also, inquire about the frequency with which the interest rate will be adjusted. For example, a five-to-one-year ARM has a five-year fixed rate. Following that, the interest rate will be adjusted annually for the balance of the loan.
Interest-only mortgages
A considerably less common third option is an interest-only mortgage. This is often reserved for rich homebuyers or those with fluctuating incomes.
As the name suggests, this form of loan allows you to pay only the interest for the first few years, resulting in lower monthly payments.
It may be an acceptable option if you expect to own the home for a short period and want to sell before the higher monthly payments begin.
However, you will not accumulate equity in the home because you will not own any more of it during the period in which you are merely paying interest. If your home’s value drops, you may owe more than it is worth.
FAQS
What are the interest rates for mortgages?
The average cost of a five-year fixed rate today is 4.44%. The best values in each of these categories are 3.89% (two years), 4.29% (three years), and 3.76% (five years).
The average two-year tracker rate mortgage is priced at 5.75%, while the best in this category is 5.39%.
What is a five-year fixed-rate mortgage?
With a five-year fixed-rate mortgage, you know the rate will stay the same for five years, so your payments will not increase during that time.
Conclusion
When you have a mortgage, you are charged interest as a proportion of the principal you have not yet paid back to your lender.
This interest represents the cost of borrowing money for a mortgage.
There are two sorts of mortgages: fixed-rate mortgages, in which the interest rate remains constant and adjustable-rate mortgages, in which the interest rate fluctuates over time.
Over time, the interest you need to repay each month reduces, and more of your mortgage payment goes into paying off the principal.
Your interest rate will be determined by a combination of Federal Reserve interest rates and your unique financial situation.