A mortgage interest rate is the cost that a lender charges you to take out a home loan, excluding any additional fees. When you repay the loan, you must pay off the principal — which is the amount you borrowed — and the interest. As such, the interest rate is represented as a percentage of the principal.
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 that the rate you’re offered is based on different factors, some of which aren’t under 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:
- Why Are Mortgage Rates Important?
- What Is More Important: APR or Interest Rate?
- What Else To Consider When Choosing a Mortgage Interest Rate
- What Changes Mortgage Rates?
- Future Mortgage Interest Rates
- The Bottom Line on Mortgage Interest Rates
Why Are Mortgage Rates Important?
Your mortgage rate determines how much you have to pay in interest. It’s written as a percentage of your home loan. Because of this, 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 impact what you owe.
Your total monthly mortgage payment is the sum of several costs, including:
- Homeowners insurance.
- Mortgage insurance (if applicable).
A higher mortgage rate typically leads to costlier monthly payments, since you’re paying a greater percentage of the principal balance in interest over time. Conversely, securing a lower interest 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 home buyers are able to afford.”
Polinori offers the following scenario for a $400,000 mortgage:
Example of how interest rates 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
A higher interest rate means that you’re going to pay more in total interest, and a big reason for this is compounding interest. With compound interest, any interest charges are added to your existing balance. As a result, the total amount you owe grows each time your interest compounds. So, the more frequently your interest is scheduled to compound, the more interest you’ll ultimately pay over time. Higher principal amounts and longer loan terms are also associated with greater compound interest.
Fixed-rate mortgages vs. adjustable-rate mortgages
In terms of interest rates, there are two main types of home loans: fixed-rate and adjustable-rate mortgages. If you have a fixed-rate mortgage, your interest rate doesn’t vary over the life of the loan. However, if you have an adjustable-rate mortgage, your interest rate can change.
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 likely adjust based on market conditions, so you must be prepared to pay more each month. 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 mortgage 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 loan origination fees. Both are important figures, but the APR provides a more accurate 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 Else To Consider When Choosing a Mortgage Interest Rate
Interest rates aren’t the only factor you should weigh when you’re considering 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,” says Mayra Rodriguez Valladares, managing principal at financial consulting firm MRV Associates in New York City. “They should look carefully to understand what is the structure of the loan.”
Even if a lender is offering a low interest rate, remember that you still have to pay additional fees to get the loan — including title insurance, loan origination fees, and more. Fees will vary between lenders, so it’s worth comparing them.
“Borrowers should also ask for a list of all fees and what they are about,” Valladares says.
By law, mortgage lenders must provide a loan estimate that lists the home loan’s projected interest rate, monthly payment, and total closing costs, which can help you understand those additional fees. You should receive the loan estimate within three business days after submitting your mortgage application.
Mortgage points, aka discount points, can help you lower your interest rate if you’re willing to pay more money upfront. Here’s how it works: 1 point costs 1% of the loan amount, and each point reduces the interest rate by a specified amount. So, if you have a $200,000 loan, 1 point would cost $2,000. Paying this fee means that the lender will cut your interest rate, resulting in a smaller monthly mortgage payment.
For certain mortgages, there’s no legal limit on how many points buyers can purchase, but lenders may impose their own rules. Before you buy any mortgage points, however, make sure that your lender has clearly explained the relationship between points and your interest rate. Also, remember that while purchasing points lowers your mortgage rate, it increases your closing costs.
Buying points may sound similar to making a large down payment, but there’s a key difference. Both mortgage points and a larger down payment can help you get a lower interest rate on the loan, but a larger down payment also lowers the principal balance.
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 in interest overall and finish repaying your loan sooner.
Since your loan term will last up to 30 years, you can think of your ties to 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.
What Changes 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 (GDP), inflation, and employment,” Valladares says.
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, 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.
The economy and inflation
Through its monetary policy, the Fed helps support a healthy economy by maintaining inflation — which is strongly correlated with employment — at 2%. For example, if inflation is under 2% and unemployment is high, the Fed may keep interest rates low to stimulate the economy. Low interest rates encourage individual households and businesses to borrow and invest money.
Once your lender has taken on your home loan, there’s a good chance that it’ll 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 with 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.
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 more likely to receive a lower interest rate. But if you have no credit or your score is on the lower end, then you’re likely 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.
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.”
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. Polinori also recommends saving up for a bigger down payment, having a low debt-to-income ratio, and maintaining an unchanged employment history for a two-year period.
Of course, all of that is easier said than done. In the end, these are goals to strive for, not absolute requirements to snag an ideal mortgage rate.
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 timing 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 homebuyer soon, you should evaluate how your current financial situation and market conditions will affect what kind of interest rates are on the table.