How Does Mortgage Interest Work?

Your mortgage interest rate has a big impact on the overall cost of your home loan, including how much you pay each month and how much you’ll ultimately pay over the life of the loan. Everyone wants a low interest rate with low fees, but how exactly do you go about getting that? In this guide we’ll discuss how mortgage rates are determined, the difference between a fixed-rate and an adjustable-rate mortgage, how to get the best possible interest rate for your home loan, and much more. Keep reading to learn everything you need to know about how mortgage interest works.

What is mortgage interest?

Mortgage interest is basically what lenders charge for letting you use their money to buy a house. It’s calculated as a percentage of the total amount of your home loan.

If you have a fixed-rate mortgage, your interest rate will remain the same for as long as you have that loan. But if you have an adjustable-rate mortgage, your interest rate could increase or decrease, depending on the market. We’ll cover these rate types in depth later on.

As part of your monthly mortgage payment, you’ll pay mortgage interest until your loan is paid off. Lenders often structure mortgage payments so that interest is paid off each month before the remainder of your payment is applied toward your loan’s principal balance. This means the bulk of mortgage payments will go towards interest in the first half of your mortgage term, be it a 15 or 30-year mortgage. Over time, more of your monthly mortgage payment will go towards your principal balance until your mortgage is completely paid off. There are also ways to pay off your mortgage early, which means you would pay less interest to your mortgage lender over the life of your loan.

How are mortgage rates determined?

Mortgage lenders, like Redfin Mortgage, set rates on a borrower-by-borrower basis. They’re determined by a combination of market factors such as how the current U.S. economy is doing, and personal factors such as the mortgage loan type and terms you choose, your credit score, and down payment amount.

Before any personal factors can be considered, mortgage rates are first affected by outside financial factors such as inflation and U.S. economic growth.

From there, your interest rate is determined by how risky a lender considers your personal home loan, which is determined by your credit score, work history, debt-to-income ratio, among other factors. The riskier the loan, the higher the interest rate usually is for the homebuyer. For example, lenders may offer a homebuyer a better interest rate if they have a very good or exceptional credit score. They may also give you a better rate if you have a larger down payment. Both of these scenarios give the lender confidence because there’s less of a chance that you’ll default on your mortgage, hence the lower interest rate.

Fixed-rate vs adjustable-rate mortgage

Fixed-rate mortgages

The two most common types of home loans are fixed-rate mortgages and adjustable-rate mortgages. A fixed-rate mortgage means the interest rate for your home loan remains constant for the entire life of your loan. Buyers who are looking for predictable, consistent payments usually prefer a fixed-rate mortgage because their interest rate stays the same and there’s very little change in their monthly mortgage payments.

Adjustable-rate mortgage

For adjustable-rate mortgages, interest rates will go up and down depending on loan terms, market conditions, and other factors. A 5/1 ARM is the most common adjustable-rate mortgage. This mortgage has a set interest rate for the first five years, then the rate adjusts once per year after that. Adjustable-rate mortgages are ideal for short-term financing or for homeowners who plan to refinance or move after five years. Typically, the interest rate for the first five years of a 5/1 ARM is considerably lower than the remainder of the loan term.

Mortgage interest rate vs APR

When learning how mortgage interest works, it's important to understand the difference between your interest rate and APR (annual percentage rate). Your mortgage interest rate is the cost you pay each year for your home loan, which will be shown as a percentage rate. Your mortgage interest rate does not take into account the fees you may have paid to your lender to complete your loan.

On the other hand, your APR, which is also expressed as a percentage, is the annual cost of your home loan, including fees. The most common fee is a loan origination fee but there are a number of other lender fees that may also apply, like processing or document prep fees, that could influence your APR.

At Redfin Mortgage, we never charge lender fees so your interest rate and APR will always be the same.

How do I get a good interest rate?

Here are the top seven things you can start doing now to increase your chances of getting a good interest rate on your home loan:

1. Improve your credit score: Borrowers with higher credit scores tend to get lower interest rates because they’re considered less risky. This is because high credit scores typically mean you consistently make regular, on-time payments towards any debts you may have, such as credit card payments or against other loans. If you have a low score, you'll want to improve it before applying for a mortgage. There are many actions you can take to improve your credit score, such as paying your bills on time and carrying a balance of only 20-30% of your available credit limit. You may also have errors or issues on your credit report that could be impacting your score, such as an unpaid bill from the past you were unaware of. Fixing those issues can help your credit score improve quickly and eliminate hassles when you apply for a mortgage.
2. Keep steady employment: You’ll typically get a lower interest rate if you can show you’ve had two years or more of steady employment. If not, you may need to explain any work gaps or times when you were unemployed. If you're self-employed, you'll need to show two years of self-employment as well.
3. Increase your down payment: Though you may not need a 20% down payment, putting more money down towards your home purchase increases your likelihood of getting a good mortgage rate.
4. Consider a 15-year mortgage: While 30-year fixed mortgages are common, if you have the funds, consider a 15-year fixed-rate mortgage as this can help lower your interest rate. However, keep in mind that a shorter term loan means your monthly payment will be higher.
5. Look into first-time homebuyer programs: There are many national, state, and city first-time homebuyer programs designed to spur homeownership in local areas. Many of these come in the form of low-interest mortgage loans.
6. Shop multiple lenders: One of the best ways to get a good mortgage rate is to shop around but make sure to compare APRs so you’re not missing any hidden fees.
7. Consider discount points: Discount points are basically a fee you can pay at closing to reduce your mortgage interest rate. Paying points can be worth it if you keep your mortgage long enough. If you refinance or sell within a few years, paying points may not be worthwhile. Your lender can help you decide.
8. Lock in your rate: Sometimes the closing process takes several weeks, and during this time rates can fluctuate. After you sign the home purchase agreement and have secured your loan, ask your lender to lock in your mortgage rate.

How to compare rates across lenders

When you're shopping around for mortgage rates, it's best to look at the following:

• Loan type
• Interest rate
• APR
• Lender fees
• Estimated monthly payment

When you’re comparing loan estimates across lenders, don’t be afraid to negotiate. Some lenders, like Redfin Mortgage, never charge lender fees and always start with their best rate, but others may waive or reduce their fees or even come down on their interest rate. Either way, it never hurts to ask.

Why it’s important to understand how mortgage interest works

While the difference between a 3.5% and 4% mortgage interest rate may not seem like much, that 0.5% can either save or cost you thousands of dollars over the life of your home loan. That’s why it’s so important to understand how mortgage interest works.