A Guide to How Mortgage Interest Works

Mortgage interest is the rate of interest that a borrower pays on the balance of their home loan after the initial down payment. Mortgage interest rates are calculated as a percentage of the total amount of money that the borrower owes the mortgage lender after they pay the down payment on their home. In general, if a mortgage lender calculates your loan to be high-risk, you will have a higher interest rate. If the risk is lower, you will likely have a lower interest rate on your mortgage.

Homeowners pay interest on their monthly mortgage payments for the duration of the loan term. Mortgage interest compounds, meaning that any unpaid interest accrues its own interest. Mortgage interest can be fixed or variable, depending on the mortgage agreement.

In a fixed-rate mortgage, your interest rate at the beginning of your loan period remains the same for the life of the loan. Fixed-rate mortgages typically incur a lower amount of interest than adjustable-rate mortgages. Adjustable-rate mortgages, also known as variable-rate mortgages, have interest rates that fluctuate depending on the financial market, real estate market, and other factors. These mortgages can be lower in certain markets, but they tend to be higher than fixed-rate mortgages.

Interest rates on mortgage loans vary from lender to lender. Financial institutions consider a number of variables when they calculate mortgage loans, including the following.

• A borrower’s credit score: A home buyer's credit score plays a significant role in determining their unique mortgage rate. Borrowers with a credit score of 740 or higher will receive the lowest mortgage rates, while those with a lower credit score can expect to pay higher interest rates.
• Loan-to-value ratio of a home: The loan-to-value ratio of a home is determined by the down payment. If a borrower pays a down payment of 10 percent of the total value of the property, the remaining mortgage loan amount is 90 percent. The loan balance gives you the loan-to-value ratio. Any loan-to-value ratio over 80 percent is considered high-risk and will incur higher mortgage interest rates.
• The type of property: Lenders will typically charge higher interest rates on higher-risk properties, such as second homes, commercial properties, investment properties, or condominiums.
• The loan type: Whether a mortgage is fixed-rate or adjustable-rate will also impact the interest rate. Adjustable-rate mortgages carry higher interest rates than fixed-rate mortgages.

Borrowers may be able to secure a favorable mortgage rate by doing a few simple pieces of due diligence.

1. 1. Make sure the borrower is a strong candidate. A borrower’s credit score is often the first thing that a lending institution looks at when they’re evaluating a candidate for financing. Paying off credit card debt and paying bills on time are simple ways for a borrower to improve their credit score in hopes of lowering their mortgage interest rates. Borrowers will also have a better chance at getting low mortgage rates if they can prove that they’ve been employed for more than two years.
2. 2. Put up a larger down payment. The more money that a borrower can pay upfront in a down payment, the lower the risk for the lender. This means that the interest rate will be lower. Borrowers can give themselves an advantage by providing a down payment of at least 20 percent of the home’s value.
3. 3. Consider a shorter-term mortgage with a fixed rate. Most lenders will suggest a 30-year loan for a fixed-term mortgage. However, if the borrower has reliable cash flow they may be eligible for a 15-year fixed-term mortgage. This way, they can pay off the loan sooner and the mortgage will accrue less interest.
   
4. 4. Shop around. Different lenders will offer different interest rates. Borrowers may want to shop around for different lenders to find the best interest rate for their mortgage.

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