How Do Mortgage Interest Rates Work? How Do Mortgage Interest Rates Work?
If you're in the market for a new home, mortgage rate fluctuations are probably top of mind as you think about purchasing a home that meets your homeownership goals and budget. Mortgage rates are determined by a variety of factors, some of which are influenced by broader market factors and some of which are influenced by the borrower(s).
Below, we'll dive into how you can positively (or negatively) impact your mortgage rate as well as what market factors to pay attention to if you're looking to gain a greater understanding of how mortgage rates work.
What is a Mortgage Interest Rate on a Home Loan?
When you borrow money to purchase a home, you are required to pay back your lender in full for the amount borrowed as well as for the cost of borrowing. The amount you borrow to purchase your home is known as principal, and the amount that your lender charges you for borrowing the principal amount is interest. Mortgage interest is charged to you as a percentage of the outstanding principal amount owed on your loan. A monthly mortgage payment includes a portion of the principal you owe your lender plus interest every month.
When you are preparing to close on a home, your lender will provide you with an amortization schedule outlining what portion of each monthly payment for the life of your loan will go toward principal and interest. You'll notice that in the first few years of repaying your mortgage, more of your monthly payment will go toward interest than principal. However, with each mortgage payment you make, the principal amount you owe on your loan will decrease, meaning the amount of your monthly payment that goes toward interest will also decrease. With time, more of your monthly payments will go toward principal which increases the amount of equity you have in your home.
How Are Mortgage Rates Determined?
Mortgage rates are determined by a range of broad economic factors but can also in part be influenced by the personal financial circumstances of each borrower.
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Broader Economic Factors |
Personal Finance Factors |
|---|---|
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Overall strength of the economy |
Down payment amount |
|
Inflation |
Loan-to-Value ratio |
|
Federal Reserve policies |
Debt-to-income ratio |
|
10-year Treasury yields |
Loan details (term, amount, type of mortgage) |
|
Housing construction costs |
Property location |
|
Stock and bond markets |
Credit score |
|
Consumer spending |
Credit history |
|
Unemployment rate |
Discount points |
The other important factor to note here is that mortgage rates vary by lender. While the broad economic and personal finance factors outlined above can still impact mortgage rates, rate shopping with different lenders will likely lead to some variance in the rate quotes you receive. This can benefit the borrower as lenders may compete with one another to offer you the most lucrative rate.
Fixed Interest Rate vs. Adjustable-Rate Mortgages
The interest rate on your mortgage is also largely determined by what type of loan you take out with your lender. There are two primary types of mortgage loans most lenders offer -- fixed-rate and adjustable-rate mortgages.
Fixed-Rate Mortgages
The traditional fixed-rate mortgage is the most common loan program, where the monthly principal and interest payments never change during the life of the loan. This type of mortgage is structured, or “amortized,” so that it will be completely paid off by the end of the loan term. Most lenders offer fixed-rate loans in terms ranging from 10 to 30 years -- 10-year fixed-rate mortgages are designed for homebuyers with greater financial flexibility looking to pay their loan off quickly while 30-year fixed-rate loan terms are great for homebuyers looking for lower monthly payments. 15- and 20-year fixed-rate loan terms offer a middle ground between affordable monthly payments and lower total interest. While one of the key benefits of fixed-rate home loans is predictable monthly payments, your monthly payment could vary if you have an escrow account. However, the principal and interest payments in a fixed-rate mortgage are generally stable and predictable.
Adjustable-Rate Mortgages
Adjustable Rate Mortgages (ARMs) are loans whose interest rate can vary during the loan’s term. These loans usually have a fixed interest rate for an initial period of time and then can adjust based on current market conditions. Adjustable-rate mortgages are usually amortized over a period of 30 years with the initial rate being fixed for anywhere from 1 month to 10 years. The interest rate for ARM loans will have a “margin” and an “index”, and their sum will be the applicable interest rate for a specified billing period. The “index” will be tied to just that, an index, such as the prime rate published by The Wall Street Journal. The “margin” will be any additional percentage rate added to the index percentage rate to calculate the interest rate during each billing period.
ARM rates may be rounded, may be fixed for specified periods of time, may be adjusted periodically, and may be capped to not exceed a certain interest rate, all pursuant to the loan terms agreed to with your lender.
Other Mortgage Options
While fixed- and adjustable-rate mortgages are the most common home loans offered by most mortgage lenders, there are several other loan types worth noting here.
Jumbo Mortgage Loans
Jumbo home loans may be available to homebuyers who are purchasing property in an expensive housing market and need to borrower more than what conventional loans allow for. As such Jumbo loans are generally a greater risk for lenders. They also have stricter qualifications and can come with fixed- or adjustable rates that are higher than traditional conforming loan types.
Interest-Only Loans
An interest-only mortgage features initial monthly payments that do not include the repayment of principal. There is an initial repayment period where only accrued interest is paid. After this initial interest-only period, monthly payments include both principal and interest. Interest-only loans are offered at either a fixed-rate or adjustable-rate. Once the loan passes the initial interest-only period, the loan becomes fully amortized with monthly payments increasing. Many borrowers may choose to refinance at the end of the interest-only period if this option is available to them.
Borrowers with sporadic incomes can benefit from interest-only mortgages. This is particularly the case if the mortgage is one that permits the borrower to pay more than interest-only. In this case, the borrower can pay interest-only during lean times and use bonuses or income spurts to pay down the principal.
FHA Loans
Federal Housing Administration (FHA) home loans are mortgages insured against default by the FHA and are available for single- and multi-family homes. The FHA doesn’t issue loans or set interest rates, it just guarantees against default. FHA loans allow individuals who may not qualify for a conventional mortgage to obtain a loan, especially first-time homebuyers. These loans offer low down payments, reasonable credit expectations, and flexible income requirements.
VA Loans
A VA loan is a loan offered to military veterans for their services. These loans are often low or zero-down payment loans backed by the Department of Veterans Affairs and issued by private lenders. Because these loans are backed by the government, they carry a lower risk for lenders and generally come with lower interest rates than conventional loans, especially for borrowers with lower credit. If you are actively serving in the military, a veteran, or a military spouse, you may be eligible to qualify for a VA loan.
How Can You Get a Lower Rate on Your Mortgage?
As mentioned above, there are a variety of factors that impact mortgage rates. While many of these factors are out of the control of any individual borrower, there are some things that you can do to positively impact the mortgage rate you receive from your lender. Improving your credit score and paying down debts before applying for a mortgage are two of the most important things you can do to qualify for a lower rate.
Shopping around with different lenders can also help you obtain a more favorable interest rate -- you may even find that if you share the rate quote you received from one lender with another lender that they might be willing to offer you a more competitive rate to try to gain your business.
One of the most common ways homebuyers obtain a lower interest rate is to buy discount points at closing. Discount points are prepaid interest on a mortgage loan, represented as a percent of your total loan, that helps you lower your interest rate during the life of the loan to make your monthly payments more manageable. Discount points are usually paid during the loan closing process and are technically part of a buyer's closing costs.
Another common way to get a lower mortgage rate once you've purchased a home is through refinancing. If rates have fallen since you closed on your home, you may be able to refinance your mortgage to a lower interest rate and thus a lower monthly payment depending on terms and fees. Refinancing can allow homeowners to obtain a shorter loan term and lower the amount of overall interest paid over the life of their loan. A cash-out refinance allows homeowners to use the equity they've built in their home to cover a range of costs including home renovations or consolidating debt.
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