How Does Mortgage Interest Work?


Mortgage rates are a critical determinant of whether a tenant makes the leap into home ownership. Lenders usually finance up to 80% of the purchase price. It is important to understand how mortgage rates work and what goes into your monthly mortgage payments before signing up.

The total monthly amount you pay may be linked to other payments, such as:

  • Fixed rate mortgages

    With a fixed rate mortgage, the interest rate is locked for the entire repayment period. Your monthly repayments are also fixed throughout.

    This type of loan usually has a long term of 30 years. Shorter repayment periods of 10, 15 or 20 years are available at a lower interest rate but higher monthly repayments.

    Example: A 30 year mortgage of $ 300,000 with an annual interest rate of 3.42% after a down payment of 20% is broken down as follows:

    • Monthly repayment for 30 years (360 months) – $ 1,577.85
    • Total Mortgage Size (Principal) – $ 240,000
    • Total Mortgage Interest – $ 144,126.57
    • Monthly $ 1,577.85 = $ 1,067.02 (principal & interest) + $ 400.00 (property tax) + $ 110.83 (homeowner insurance)

    To begin with, around 75% of your loan repayment will be applied to the interest, while 25% will be applied to the principal. As your accrued interest decreases, more and more of your monthly fee will be applied towards the principal loan amount. This is known as building capital.

    Ultimately, when you make your final payments, the entire monthly fee will be used to pay out the principal.

    A mortgage calculator can help you paint a financial picture for years to come.

    A financial tip for lowering your interest rates over time is to apply lump sum payments to the principal amount of the mortgage loan. A smaller capital means less interest.

    Think of year-end bonuses, tax refunds, and other extra monies. Or you can add the lump sum to your monthly savings budget. If you need help saving money, here’s a quick beginner’s guide on how to save money.

    The main benefit of fixed rate mortgages is predictability. You know how much you will be paying monthly for the next 30 years. You are protected from interest rate fluctuations.

    Longer repayment periods allow you the lowest monthly payments, but cost more overall because you pay more interest.

    Shorter payment periods have lower interest rates, but the monthly burden on your budget is much higher.

  • Adjustable rate mortgages

    With this type of loan, the interest rate is variable. The lender usually starts with an initial interest rate that is lower than that of a comparable fixed rate loan.

    As the repayment period progresses, the interest rate increases slowly. If left on long enough, the interest rate can potentially outperform that of fixed rate loans.

    Some of the considerations and conditions to be aware of with adjustable rate mortgages (ARM) include:

    • The adjustment frequency is the period between rate hikes and is usually set in advance.
    • Adjustment indices are the benchmark on which your interest rate adjustment is based. The benchmark could be the interest rate on Treasury bills.
    • The margin is the amount above the adjustment index that you want to pay for your mortgage interest rate.
    • Upper limits refer to the limit by which the adjustment is increased per period. In the case of a negative amortizing loan, this is a cap on your total monthly payment.
    • The cap is the highest amount that your interest rate can reach over the life of the loan.

    Please note that in the case of negatively amortizing loans, the upper limit only applies to part of the interest. When the interest is incurred, it becomes part of the principal, resulting in an amount owed greater than the amount borrowed.

    Example: A 5/1 hybrid ARM starts with a five year period at a fixed rate. After that, the interest rate increases according to the upper limit per period until you have completed the repayment of the loan or the interest rate reaches the upper limit. Here is a breakdown:

    • A $ 200,000 loan for 30 years is charged 4% for the first five years
    • The monthly repayment for the first 60 months is $ 955
    • The rate increases by 0.25% over the next 12 months to $ 980, then to $ 1055 the following year, and so on.
    • These amounts do not include insurance and taxes.

    The main advantages of ARMs are:

    • They are cheaper than fixed-rate loans for up to seven years in the short term.
    • The borrower may qualify for a larger loan due to lower initial payments
    • In a falling interest rate market, the borrower enjoys lower interest rates and repayments without having to refinance the mortgage

    The main disadvantage of ARMs is the fluctuating monthly payment, which can be a significant drain on large loans or when the interest rate doubles.

  • Interest Loans and Jumbo Mortgage Loans

    These third and fourth loan options are primarily aimed at wealthy homeowners.

    With interest-free loans, your monthly payments can only be applied to the interest for the first few years. The monthly payments will be lower, but you will not build up equity. This type of loan is best for the homeowner who is expecting to sell and move on soon.

    Jumbo mortgage loans are those where the loan amount is greater than the loan limit set by the Federal Housing Agency. The US national baseline in 2021 is $ 548,250. In certain parts like New York, San Francisco, Hawaii, and Alaska, the limit increases by 150%.

    Jumbo mortgages can be fixed rate, variable rate, or interest-only. In all cases, the interest rates tend to be higher.

  • Other costs

    Even with a high interest rate, other costs associated with the homeowner can add to your monthly repayment.

    Real estate taxes and homeowner insurance are sometimes included in mortgage payments by lenders. The money is kept in an escrow account so the lender can pay the bills that arise.

    Homeowner’s Association (HOA) fees can also be quite high depending on the location and type of property.

    The type of mortgage you choose depends on how much you can pay monthly and how long you plan to live in the house. Interest rate forecast trends are important and whether you have enough cushion to fund ARMs.

  • Your main goal is to get an interest rate that is good for your pocket and brings you closer to your financial goal of being a homeowner. The interest rates are determined based on the rate set by the Fed and your creditworthiness. See How Your Credit Score Can Affect Your Interest Rates!

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