A mortgage interest rate is part of the costs that a lender charges you to take out a home loan. When you repay the loan, you must pay off the principal — which is the amount you borrowed — and the interest that accrues on it.
Scoring a lower interest rate can help you save money over the life of your loan. However, it’s important to remember that your interest rate is only one factor that contributes to the total cost of borrowing money — and the rate you’re offered is based on several factors, some of which are out of your control.
Although you can’t change current housing market conditions or the direction in which interest rates are trending, understanding how mortgage rates work puts you in a better position to know whether you’re getting a good deal on your home loan.
Learn more about how mortgage interest rates work and why they matter:
- What Are Mortgage Rates?
- Why Are Mortgage Rates Important?
- What Is More Important: APR or Interest Rate?
- What Factors Affect Mortgage Rates?
- How To Get a Low Mortgage Rate
- What Else To Consider When Choosing a Mortgage Interest Rate
- Future Mortgage Interest Rates
- Mortgage Interest Rate FAQ
- The Bottom Line on Mortgage Interest Rates
What Are Mortgage Rates?
Mortgage rates are the interest rates that apply to home loans. Every loan has an interest rate, which, combined with the loan balance, determines the amount of interest that accrues each month.
Mortgage rates can be fixed or adjustable. Fixed-rate loans offer more certainty and are good to lock in when rates are low. Adjustable-rate mortgages have rates that are initially lower in most cases but will adjust from time to time and may increase.
Each month, you pay the accrued interest on your loan, plus a portion of the principal. That means the interest rate influences your monthly payment and the total cost of your loan.
How do mortgage rates work?
Though there are factors that influence the housing market as a whole, the mortgage rates that people qualify for can vary from borrower to borrower.
A major factor that affects the rates you earn is your credit score. In general, the better your credit, the lower the interest rate you can get.
Why Are Mortgage Rates Important?
Your mortgage rate determines how much you pay in interest on your home loan. Cutting your mortgage rate by just a fraction of a percentage point can save you thousands of dollars in total interest.
Here are some ways that current housing interest rates can affect what you owe.
Your monthly mortgage payment is the sum of several costs, including:
A higher mortgage rate typically leads to costlier monthly payments. Conversely, securing a lower rate can help lower your monthly payments.
“Interest rates affect homebuyer affordability in regard to how much a homebuyer can spend on a home,” says James Polinori, chief marketing officer at direct mortgage lender Geneva Financial in Chandler, Arizona. “When interest rates dip, a homebuyer can afford to spend more on a house while keeping the payment lower. The reverse is true as well; higher interest rates decrease the amount that homebuyers are able to afford.”
Polinori offers the following scenario for a $400,000 mortgage:
Example of How Interest Rates Can Affect a 30-Year Fixed-Rate Mortgage
|Loan amount: $400,000
|Loan amount: $400,000
|Interest rate: 4%
|Interest rate: 5%
|Monthly payment: $1,910
|Monthly payment: $2,147
As you can see, increasing the interest rate by 1 percentage point translates to a payment difference of $237 per month — a 12% surge.
“This means at 4% a homebuyer can afford a $400,000 house, but if rates rise to 5%, the homebuyer can only afford $355,000 to keep the same payment of $1,900 per month,” Polinori says. “The difference of $45,000 is no small chunk of change.”
Total interest paid
In the United States, mortgages generally use simple interest. Simple interest does not compound and is calculated using the principal of your loan, not including the interest that has already accrued.
Over time, as your payments reduce the principal, less interest will accrue. This allows a larger portion of your payment to go toward principal and less toward interest. Your first payments may go almost entirely toward interest, while your last few payments will go almost solely toward principal.
The higher the interest rate on your loan, the more you’ll pay each month and in total.
Fixed-rate mortgages vs. adjustable-rate mortgages
There are two main types of interest rates for home loans: fixed-rate mortgages and ARMs. If you have a fixed-rate mortgage, your interest rate doesn’t change over the life of the loan. However, if you have an ARM, your rate can change periodically.
Compared to fixed-rate mortgages, ARMs may start you off with a lower interest rate during an introductory period, which can last a few months or years. After that, your interest rate will adjust from time to time and may increase depending on market conditions, so you need to be prepared for changes in your monthly payment.
You’ll want to ask your lender about how much your interest rate can fluctuate and how frequently it will change, as well as how soon the first adjustment will occur and how it can affect your monthly payment. Make sure you can still afford the loan if your rate increases to the maximum limit.
What Is More Important: APR or Interest Rate?
If your interest rate represents the yearly cost of the loan, then your annual percentage rate is the yearly cost of the loan plus fees. Typically, these fees include certain closing costs, such as the loan origination fee.
Both are important figures, but the APR provides a more complete picture of what you’re truly paying and can help you compare the costs of different loans. However, keep in mind that your monthly payment is based on the loan’s interest rate, not the APR.
What Factors Affect Mortgage Rates?
The biggest factor that affects your mortgage rate is how much risk you pose to the lender, according to Polinori.
“When judging risk, the higher the risk, the higher the interest rate; the lower the risk, the lower the interest rate,” he says.
However, some of the reasons why mortgage rates change have nothing to do with you as a borrower.
“Interest rates are influenced by numerous country and economic factors such as the level of gross domestic product, inflation, and employment,” says Mayra Rodriguez Valladares, managing principal at financial consulting firm MRV Associates in New York City.
Your credit affects the mortgage interest rate you’re able to get, because lenders use your credit history to gauge how much of a risk you pose when it comes to repaying the loan. If you have a higher credit score, then you’re perceived as more likely to pay back the loan, and you’ll likely receive a lower interest rate. But if you have no credit or your score is on the lower end, then you’re probably going to get stuck paying a higher interest rate.
“Borrowers are often quoted average estimated interest rates when they are in the initial stages of shopping rates. What many don’t know is that their own personal financial picture will have a huge impact,” says Michele Anapol, a loan officer with Jet Direct Mortgage in Coral Springs, Florida. “A borrower’s credit score, debt-to-income ratio, and more will all play a key role in determining whether the final rate they lock in moves higher or lower.”
Your interest rate can vary significantly depending on the type of mortgage you choose.
Loans insured by the Federal Housing Administration may come with more-competitive interest rates than conventional mortgages because FHA loans are backed by the government, lowering the risk to the lender. These loans are often the cheapest option if you have a lower credit score or can only make a smaller down payment.
VA loans and USDA loans — which are insured by the Department of Veterans Affairs and Department of Agriculture, respectively — can be even more affordable than conventional or FHA loans for those who qualify.
Mortgage points, aka discount points, can help you lower your interest rate in exchange for paying more upfront at closing.
Here’s how it works: 1 point costs 1% of the loan amount, and each point reduces the interest rate by a specified amount. Paying this fee means that the lender will discount your interest rate, resulting in a smaller monthly mortgage payment.
Before you buy any mortgage points, however, make sure that your mortgage lender has clearly explained the relationship between points and your interest rate. Also, remember that just because a lender offers points on their loan, that doesn’t necessarily make it cheaper than a loan with no points from a different lender.
Your amortization period refers to your loan term, or the amount of time it takes to pay off the mortgage. Loans with a shorter amortization period typically have higher monthly payments but lower interest rates and total costs.
Choosing a 15-year mortgage vs. a 30-year mortgage means you’ll save money on interest since you’re paying off the loan in half the time. So, if you can afford to make larger monthly payments, opting for a 15-year amortization period will allow you to pay less interest overall and finish repaying your loan sooner.
The economy and the Federal Reserve
The Federal Reserve is the central bank of the United States. It implements the country’s monetary policy and monitors risks to the U.S. financial system. One of the Fed’s key functions is to manage short-term interest rates by setting a target range for the federal funds rate, or the interest rate at which banks lend money to each other overnight to meet their reserve requirements.
The federal funds rate is important because it influences other types of interest rates — including longer-term interest rates on mortgages. The Fed can raise interest rates when inflation is high and employment is strong, which makes it more expensive to borrow money. But the Fed can also cut interest rates during an economic downturn, which makes buying a home and refinancing a mortgage less expensive.
Once your lender has taken on your home loan, there’s a good chance that it will offload the loan on the secondary mortgage market. In the secondary mortgage market, buyers — like the government-sponsored enterprises Fannie Mae and Freddie Mac — combine mortgages into securities and sell them to investors like insurance companies, investment banks, and pension funds. This gives mortgage companies a reliable supply of money to lend and minimizes the risk associated with the loans, which affects mortgage rates by keeping them lower and steadier.
The federal government sets certain rules that lenders must follow to protect consumers, and your mortgage interest rate can be affected by changes in lending regulations. For example, the Home Ownership and Equity Protection Act of 1994 created new disclosure requirements and limitations on certain loans with high interest rates and fees. In 2008, additional legislation was passed to protect consumers from deceptive or unfair lending practices during the subprime mortgage crisis.
How To Get a Low Mortgage Rate
Securing a low mortgage rate can be mostly about timing. If you apply for a mortgage when market interest rates are low, then you can land a good deal, if qualified.
Outside of timing, there are a few things you can do to get a low interest rate on your mortgage:
- Maintain a great credit score by always making your payments in full and on time, and limiting your debt as much as possible.
- Try to save for a bigger down payment. The larger your down payment, the less risk the lender takes on, and the lower the interest rate you can secure, if otherwise qualified.
- Have a low debt-to-income ratio by working to reduce your total debt and increase your income.
- Consider buying mortgage points to lower your rate. This typically makes sense when you plan to keep the loan for a long time.
- Shop around and compare loan offers to see which mortgage lender offers the best deal.
To increase your chances of getting a lower interest rate, Polinori suggests assessing your own risk factors. He says it’s a good idea to check your credit every six months to make sure there aren’t any errors on your report that could cost you.
What Else To Consider When Choosing a Mortgage Interest Rate
Interest rates aren’t the only factor you should consider when choosing a mortgage offer.
“It is understandably tempting to go with the lender with the lowest mortgage rate, but borrowers should ask questions about all elements of the contract,” Valladares says. “They should look carefully to understand what is the structure of the loan.”
When a lender is offering a low interest rate, remember that you’ll pay additional fees to get the loan — including origination fees, PMI if applicable, and more. Fees will vary between lenders, so it’s worth comparing options.
By law, mortgage lenders must provide a loan estimate that lists the loan’s projected interest rate, monthly payment, and total closing costs. You should receive the loan estimate within three business days after submitting your mortgage application.
“Borrowers should also ask for a list of all fees and what they are about,” Valladares says.
Since your loan term will last up to 30 years, you can think of your mortgage lender as a long-term business relationship. As such, you should pay attention to how trustworthy and reliable the lender is known to be.
“The most crucial factor in choosing a lender during a home purchase or refinance transaction is communication and trust,” Polinori says. “It’s extremely important to not only find a company that has an excellent reputation but to also find a loan officer with experience and knowledge in their field.”
In addition to your own impression of the lender, you should check out online reviews.
“Borrowers should do research at business bureaus, consumer reports, and social media about the reputation of the lender,” Valladares says.
Future Mortgage Interest Rates
How do you know whether mortgage rates are going up or down? It can be useful to keep track of the federal funds rate to forecast where mortgage rates might be headed.
“Borrowers should monitor U.S. Treasury yields as well as interest rate futures to estimate the direction of mortgage rates,” Valladares says. “They should also read Federal Reserve reports about the U.S. economy. In addition, reports from Freddie and Fannie Mae are also useful.”
Mortgage Interest Rate FAQ
Mortgage rates are a complicated topic, so it’s understandable to have questions about how they work.
One major reason why mortgage rates are currently high is the effective federal funds rate. As of Jan. 27, 2023, the effective federal funds rate is 4.33% — the highest it has been since 2007.
If you buy when rates are high, you have a few options. One option, of course, is to keep the loan. However, if rates fall, you can consider refinancing to a mortgage with a lower interest rate, if qualified.
The Bottom Line on Mortgage Interest Rates
Mortgage interest rates are just one piece of the homebuying puzzle, but they can have a big impact on how much you pay each month and over the life of your loan. While mortgage rate changes can signal the right time to take out a home loan, there are many different factors — within and outside of your control — that will influence the interest rate you get. If you’re looking to become a first-time homebuyer soon, you should evaluate how your current financial situation and market conditions will affect what kind of interest rates are on the table.
T.J. Porter contributed to the reporting of this article.