You’ve probably overheard homeowners boast that they nabbed a “great interest rate” on their mortgage. But what is the definition of interest, exactly? Essentially, interest is an extra fee you pay your lender for borrowing the money to buy a home. Lenders, after all, don’t just let you borrow money out of the goodness of their hearts.
“They want to be compensated for putting money in your pocket,” says Jack Guttentag, author of “The Mortgage Encyclopedia.”
Since mortgage lenders are providing cash upfront to make homeownership possible, they require you to repay every penny you borrow, plus interest. Now, if you’ve got a lot of dough lying around in a savings account and want to pay for the whole house upfront (or most of it) with an all-cash offer, you can avoid paying interest or snag a very low interest rate.
But let’s face it, most of us aren’t living in this dreamy scenario, which makes home loans and interest par for the course—so it pays, literally, for a borrower to know how it all works—the interest rates, the fluctuations, the fees, all of it.
How interest rates on home loans work
When you get a mortgage loan, your interest payment is calculated as a percentage of the total loan amount you’re borrowing. For example, the general formula dictates that if you get a 30-year $200,000 loan with a 4% interest rate (often expressed as the annual percentage rate or APR), you will end up paying back not only that $200,000, but an extra $143,739 in interest—so you’re looking to borrow a total amount of $343,739.
Month to month in the above scenario, your mortgage payments would amount to about $955 per month. Part of that monthly payment would go toward paying back what you borrowed (this is known as your principal), and the rest goes toward interest.
The exact proportion varies month to month—early on, homeowners pay more interest and less principal—but that composition changes as the loan matures.
For instance, in your very first month for the above scenario, you’d pay $288 to your principal and $666 to interest. By the second year, and every year after, you’ll see those figures slowly reverse, meaning that a higher percentage of your monthly mortgage loan payment will be applied to the principal; and by your last check to your lender 30 years later, you’d pay $951 toward principal and $3 toward interest (check out realtor.com®‘s mortgage calculator to punch in your own numbers).
So what does this payment schedule mean for borrowers? It means it will take time for you to build equity in your home, since you’re largely paying interest during the early years as a borrower. Yet there’s an upside to this reality: If you file a Form 1040 and itemize your deductions, the interest on a home loan is deductible on your taxes (there are some limitations). That means that early on, you will get a big tax break that dwindles as your equity rises.
Why interest rates fluctuate
Interest rate fluctuations are based on several factors.
“During a period of slack economic activity, [the Federal Reserve] will provide more funding and interest rates will go down,” says Guttentag. Conversely, “when the economy heats up and there’s a fear of inflation, [the Fed] will restrict funding and interest rates will go up.”
These financial shifts could be stressful if they affect your monthly mortgage payments. Luckily, when you get a home loan, there’s a way to shield your savings account from this roller coaster by getting a fixed-rate mortgage, which locks in your rate at whatever level it is at the time you apply. It will then remain the same over the life of your loan (typically 30 years). Alternatively, if you don’t mind the market’s ups and downs, you can opt for an adjustable-rate mortgage.
How to get a low-interest loan
Not everyone who applies for a mortgage loan gets the same interest rate. It varies widely depending on a variety of factors.
Probably the biggest variable is you: Interest rates for home loans vary depending on the borrower’s credit score. Good credit leads to lower interest rates, which is why it’s important to know your credit score and keep it stellar. Your interest rate can also vary based the type of loan you get: 15-year loans, for example, typically offer lower interest rates than 30-year loans. ARMs have lower interest rates than fixed-rate mortgages (at least at first).
The bottom line: Paying interest may be a reality of homeownership, but how much interest you pay depends on many factors, so make sure you grasp the basics before you apply.
The post What Is Interest? The Fee That Can Tack Thousands Onto Your Mortgage appeared first on Real Estate News & Insights | realtor.com®.