How does mortgage interest work? How is your interest rate calculated?
Purchasing a home is costly and most likely requires taking out a loan. Before applying, one of the factors to keep in mind is the interest on the mortgage.
When purchasing a house, you’ll most likely have to take out a loan. Before going to a lender to apply, one of the key elements to keep in mind is the interest you will have to pay on your mortgage.
How is your mortgage interest rate calculated?
Several factors go into determining what interest rate you will have to pay on your mortgage. These include the type of loan you apply for, what the market rate is and your creditworthiness to name a few.
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Type of loan
There are several types of mortgages but the two main categories are those with a fixed rate and flexible rate. There are pros and cons to both, with one of them being the interest that you pay in the former locked in for the duration of the loan, while the later could experience swings.
Current market rate
One of the most important factors determining the range of mortgage rates that a lender will offer is the market. Mortgage rates track the yield on 10-year Treasury Bonds which is related to the Fed’s economic outlook.
Creditworthiness
Your credit score will also play a major role in your qualifying for a loan and the interest you will have to pay. This is calculated based primarily on your payment history as well as how much you owe compared to your income. The higher your credit score the better the rate that a lender may be willing to offer.
How much you borrow
Typically, the bigger the loan you ask for, the higher the interest rate the lender will charge. This is because the lender will consider that you pose more of a default risk.
The length of the mortgage
The longer you will take to pay back a loan, the higher your mortgage rate will be. Again, because you may pose a greater risk of default.
For example, the current weekly average for a 30-year fixed-rate mortgage has been hovering between 6 percent and 7 percent since November 2022. While the 15-year fixed-rate mortgage has generally been around 0.6 percent lower. Experts believe that they will stay elevated through this year and into the next.
How does mortgage interest work?
The interest rate will apply to the balance of your loan which could include other expenses than just the cost of the property. These may include closing costs, homeowners insurance and even property taxes. Additionally, you may have to purchase private mortgage insurance (PMI) with a conventional loan if the loan-to-value ration is greater than 80%.
At the beginning, the bulk of your payments will be towards the interest on you mortgage. However, as the principal is paid off, the amount of interest that you pay each month will progressively be reduced. By the end, the majority of each payment will go towards the principal.