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How Does Mortgage Interest Work?

When applying for mortgages, many don’t consider the role that interest plays in determining the total cost of their loans. They usually focus on making sure the monthly payments are affordable.

Not considering the impact that interest has on your mortgage could be a costly mistake. A single point increase or decrease in the interest rate you pay could either add or subtract tens of thousands of dollars to the total cost of your home loan.

How is mortgage interest calculated? The following overview can help you understand how interest works to help you make an informed decision when selecting a mortgage.

What Is Mortgage Interest?

Interest is the fee you pay your lender for the money you borrow. How much interest you pay depends on the amount you are borrowing and the length of your loan. You will pay more in interest with a longer loan, for example, than with a shorter loan.

Let’s assume, for example, that you finance $250,000 with an interest rate of 5%. If you finance the loan for 30 years, you will pay a total of $233,139.46 in interest. If you finance the same loan for 15 years, however, you will only pay $105,857.13 in interest.

How Is the Interest Rate Determined in Mortgages?

The interest rate you pay on a mortgage is largely determined by market forces outside of your lender’s control. There are, however, some additional factors that influence rates.

Your Credit Score

Credit scores are good indicators of how much risk you will be to your lender. Because of this, those with the highest credit scores are often rewarded with the lowest possible interest rates for their good payment histories.

Home Location

Mortgage interest rates vary depending on the state and the county. This is because different localities have different laws on how lenders can recover what’s owed in the event of a foreclosure.

Down Payment

Typically, those who make high down payments on their homes receive lower interest rates. A high down payment decreases the risk to the lender because more equity is owned in the home.

Loan Type

Different mortgage types have different interest rates. Government-backed loans (e.g., FHA, USDA, VA) may have rates that are different from conventional loans.

What Is the Prime Rate?

The prime rate is the best possible interest rate that a lender will offer to borrowers. It is usually extended to those with the highest credit scores. Some banks may reserve their best rates for long-term customers or corporate clients. 

Three Ways Interest Is Used in Mortgages

Mortgages typically have interest rates that are either fixed or variable. It’s also possible to structure an interest-only mortgage in some cases. There are certain benefits to each loan type.

Fixed-Rate Mortgage

Mortgages with fixed interest rates will have the same interest rate throughout the loan. If you have a 30-year mortgage with a 5% interest rate, for example, the rate will be 5% from the first day through the end of the 30 years. The interest rate you will pay is locked in when the loan is created.

The primary advantage of fixed-rate mortgages is their predictability. The monthly payments will always be the same amount. Knowing exactly how much you will have to pay each month helps with budgeting.

Adjustable-Rate Mortgage

With an adjustable-rate mortgage, the rate is usually fixed for the first 5-10 years. After that, it is allowed to fluctuate with the market.

Adjustable-rate mortgages may be good options for those who know they won’t be living in an area for a long time. During the initial fixed-rate period, the rate may actually be lower than the rate in a fixed-rate mortgage, thus allowing the buyer to save money on interest.

Interest-Only Mortgage

With an interest-only mortgage, you do not repay the principal. The full amount of the monthly payments you make go towards the interest. A lender may structure an interest-only payment as a short-term loan when people are both buying and selling homes at the same time.

Let’s say, for example, that someone wants to buy a new home but that person’s current home hasn’t sold yet. An interest-only loan would allow that person to go ahead and buy a new home and make interest-only payments on it. When the home sells, a new loan is then obtained where the proceeds from the sale are used as a down payment.

How Is a Mortgage Payment Calculated?

Each mortgage payment you make consists of four items—principal, interest, taxes, and insurance (PITI). The principal is the money you borrowed, and the interest is the fee you pay your lender for borrowing the money.

Property taxes are collected and then remitted to the municipality on your behalf. Finally, lenders may require you to have private mortgage insurance (PMI), which protects the lender in case you stop making payments on the loan. Most lenders do not require PMI with down payments of at least 20%.

Lenders use a standardized formula to calculate your monthly mortgage payments. Although the formula is complex, you can estimate your monthly payments by using an online mortgage calculator.

How Much of My Monthly Mortgage Payment Is Interest?

The amount of interest you pay each month on your mortgage changes throughout the loan term. In the beginning, the majority of your mortgage payments will be interest.

As you repay the principal, however, less interest will accrue, and a higher percentage of your payments will go towards the principal. As you reach the end of your mortgage payments, nearly all of your payments will go towards the principal. 

Home Loans with Credit Union of America

If you are currently shopping for a mortgage, Credit Union of America offers several great options including conventional, FHA, VA, and Rural Development loans. You may also qualify for a home loan with no down payment and no PMI requirements.

Our rates are competitive, and applying is quick and easy. Click below to learn more about our home loans. You may be closer than you think to either buying a home or refinancing an existing mortgage.


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