How Does Mortgage Interest Work?

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When you buy a house, you’ll likely need to get approved for a mortgage loan from the bank. Depending on the time-frame of the mortgage, you will be paying it back for 15, 20 or 30 years — with interest of course!

When I purchased my first home at the age of twenty-three, I wondered, “So how does mortgage interest work, and how does it affect my monthly budget?”

Two Types of Interest Rates for Mortgages

There are two different types of mortgage rates. The first is known simply as the “interest rate” and is used by the loan company to calculate your monthly payments. The second is known as the APR or the “annual percentage rate“.

The APR tells you what your effective interest rate is after all the extra costs, such as loan origination fees, application fees and prepaid interest points are added up. This is why your APR will always be higher than the originally stated interest rate. You know the loan company has to get their cut!

Basically, the APR will help you compare loans, and find the best interest rate possible. While the APR doesn’t directly affect your monthly payments, lenders are required by law to disclose the annual percentage rate.

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How Your Monthly Mortgage Payment is Calculated

When I started budgeting to buy my first home, I thought the only thing I had to worry about was the principal and interest for the monthly payment. But as we’ve learned above, there are lots of added fees and charges that add up to make your total mortgage payment.

Many mortgage companies (especially in this economy) will only allow you to get approved for a home loan if you can prove you have homeowner’s insurance lined up for it. This cost, along with your real estate taxes, will often be put into an escrow account, where your monthly payment will not only include the principal and interest figures, but your insurance and taxes.

To get an accurate figure of what your monthly payment will be, you’ll need to first figure out how your interest rate is calculated. The interest rate on nearly all mortgages is computed monthly, so if you divide the annual rate by 12 you’ll get the monthly interest rate.

You can use this simple mortgage calculator, like this one from Zillow, to accurately compute your monthly mortgage payment — which includes your principal, interest, taxes and insurance.

This mortgage payment example is calculated on a 30-year fixed loan, with a 10% down payment, at the national average interest rate at 4.335%. It also includes the average amount for real estate taxes, homeowner’s insurance and private mortgage insurance.

The Difference Between a Fixed-Interest and an Adjustable-Rate Mortgage.

The calculations above were for a fixed-rate mortgage, but the computations for an adjustable-rate mortgage, or ARM, work in the same way.

Every time the interest rate on an ARM goes up or down, your mortgage lender recalculates your payments so they’ll be equal, until the rate adjusts again. They do this so you’ll continue to stay on track and have the principal paid off by the end of loan term.

If your interest rate goes up with an ARM, your monthly payment goes up too. However, if you have fixed-rate loan, your interest rate will stay the same — until you refinance — and your monthly payment will stay the same.

Adjustable-rate mortgages are quite risky, for this reason, so take caution before applying for an ARM.

A Few Factors That Determine Your Interest Rate

As we can see in the chart, the better your interest rate is, the lower your monthly payment will be — since this is one of the only figures you have control over (unless of course you negotiate a better rate on your homeowner’s insurance policy).

There are a few factors that determine your interest rate.

1. Your credit history. Obviously, the higher your credit score and the better your credit history, the lower the interest rate you can get on your mortgage. This is why it’s important to build a solid credit history before purchasing a home.

2. Your down payment. As a rule of thumb, you want to put down at least 20% of the principal balance towards your mortgage loan. So if the purchase price of your home is $200,000 your down payment will be $40,000 (or 20% of $200k). The larger your down payment, the better interest rate you’ll qualify for.

3. The housing market. If the economy is doing well and interest rates are up, you’ll likely pay a higher interest rate on your mortgage. But if the housing market is down, you have a much higher chance of getting a lower interest rate.

How Refinancing Can Save You Money

Your goal is to only apply for fixed-rate mortgage loans when possible, because an adjustable-rate mortgage’s interest can skyrocket after a certain term — most likely after 3 or 5 years.

Either way, you’re not stuck with the current rate you have, in the event your interest rate is high or you have an ARM. Refinancing your home loan, could be a smart move, and save you a ton of money on interest.

Just remember that it needs to payout within 2 years or less to be worth the added expense. You’ll have to budget for additional closing costs when refinancing, but it could be worth it if you have save 2% or more off your current interest rate. And a 2% interest savings on $200,000 is quite a hefty chunk over a period of ten or twenty years.

One Method to Cut Your Mortgage Debt Payment Time in Half

One of the smartest strategies I ever implemented with my mortgage, was making biweekly payments, instead of monthly payments. Basically you split your loan payments in half and pay this amount automatically, every other week versus once a month.

How does this help cut your debt repayment time in half?

You’ll make 26 biweekly payments every year, or 13 payments, as opposed to the 12 monthly payments you’d normally make. This one extra payment can save you thousands of dollars on interest and take years off the life of your loan.

You’re effectively lowering the average daily balance by making these payments a bit earlier than normal, which means the interest charged on your account is smaller — saving you more money on interest payments over time.

This is something ReadyForZero offers to help simplify your life and get out of debt faster! Now you can set up automatic biweekly payments, and cut your debt payment time by nearly half.

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  • http://www.hashdoc.com/ Amy

    Thanks so much for this post! I’m not a homeowner (and probably won’t be one for quite awhile), but I have been wondering about real estate taxes and how that works… This definitely answered my question! I am also wondering, how do property taxes work when the mortgage is all paid down and you have the deed to the house?

    • http://www.twitter.com/bwfeldman Benjamin Feldman

      I’m so glad you liked the post, Amy! That is a good question about property taxes – my understanding is that your property taxes will continue to be the same amount after you pay off your mortgage (the mortgage itself doesn’t determine how much you owe). But it might be worth doing a bit of Googling to make sure this is correct. If you find anything that says different, please let us know!