How does mortgage interest work?

Wed Jun 15 2022

Surface level view of man and woman leaning on kitchen island, face to face and smiling, as they begin home purchasing process

Most homebuyers need a mortgage before they can afford a house. But like anyone who borrows money, people who take out a mortgage end up paying the amount they borrowed plus more in interest.

Your mortgage interest can cost you hundreds of thousands of dollars. Let’s take a closer look at how mortgage interest works on different loans and what might be the best option for you.

What is a mortgage interest rate?

A mortgage interest rate is what it costs you to borrow money so you can buy a home. Lenders typically charge a percentage of the principal amount or the amount you’re borrowing, as interest. This is how they make money on your loan.

Your mortgage interest rate is different from your annual percentage rate (APR). An APR includes your mortgage interest rate plus any discount points and broker fees. For this reason, your APR is often higher than your mortgage rate.

How does interest work on a mortgage?

How mortgage interest works depends on the type of mortgage you get. Generally, you have three types of loans to choose from when you buy a home:

  1. Fixed-rate mortgage
  2. Adjustable-rate mortgage
  3. Interest-only mortgage

The most common type is a fixed-rate mortgage followed by an adjustable-rate mortgage. Interest-only loans are much rarer than these and are usually only given to homebuyers who are wealthy or who have irregular incomes.

Fixed-interest rate mortgage

A fixed-interest rate mortgage is one where your interest rate is set for the entire life of the loan. Mortgages typically last anywhere from 10 to 30 years, or even longer. Choosing a mortgage with a shorter term can increase your monthly payments because the loan needs to be repaid sooner, but your mortgage interest rates may be lower than it is on longer-term mortgages.

Your monthly mortgage payment goes towards paying off your loan’s interest and principal. In the early months, a larger chunk of your payment goes towards your interest than to your principal. But as time passes, your principal decreases and accrues less interest. This means more of your monthly payment can go to paying off your principal.

You should also note that while the mortgage interest on a fixed-rate loan doesn’t change, you may get a chance to refinance your mortgage at a different rate. This requires you to apply and re-qualify for the lower mortgage interest rate.

Adjustable-rate mortgage

An adjustable-rate mortgage (ARM) does not permanently lock in your mortgage interest rate for the duration of your loan. Instead, the mortgage interest rates on ARMs can adjust as often as once per year, but most have limits on how often or how much they can adjust.

Like a fixed-interest rate mortgage, ARMS can have a term of up to 30 years, and your monthly payments go towards paying off your principal and your interest. Borrowers find ARMs attractive because they often start with a low interest rate which makes them more affordable in the early years. However, you may find your monthly payments difficult to maintain as interest rates change.

One way to avoid this trouble is to look at how often an ARM adjusts. For example, the mortgage interest rate on a three-year ARM can be adjusted every three years.

Interest-only mortgage

Unlike the monthly payment for ARMs and fixed-interest rate mortgages, the monthly payment for an interest-only mortgage only goes towards your interest at the start of the loan. This keeps your payments low for a set time. Once the interest-only period ends, you're responsible for paying both the principal and the interest.

If you’re not planning on staying in the home for a long time, an interest-only mortgage can make it easier for you to afford a pricier home. However, this is still a risky mortgage to take on because you don’t build up equity until you start paying your principal. Worse? You can lose any equity you gain from your down payment if housing prices suddenly decline.

How is mortgage interest calculated?

Lenders calculate mortgage interest by the month. To get a general idea of your monthly payment, you multiply the remaining principal on your loan by your interest rate and divide that resulting number by 12.

If you want a more accurate estimate for your monthly mortgage interest, you can try one of the many mortgage calculators available online. This mortgage calculator not only gives you an estimate for your monthly payment, but also factors in other costs like homeowners insurance, property taxes, and private mortgage insurance.


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