How does mortgage interest work?

When you take out a mortgage, your lender is paying you a large loan that you use to purchase a home. Because of the risk it’s taking on to issue you the mortgage, the lender also charges interest, which you’ll have to pay back in addition to the mortgage.

Interest is calculated as a percentage of the mortgage amount. If you have a fixed-rate mortgage, your interest rate will stay the same throughout the lifetime of the loan. But if your mortgage is an adjustable-rate mortgage, your interest rate could increase or decrease, depending on market indexes.

But interest also compounds: unpaid interest accrues to the mortgage principal, meaning that you have to pay interest on interest. Over time, interest can cost nearly as much as the mortgage itself.

Mortgage payments are structured so that interest is paid off sooner, with the bulk of mortgage payments in the first half of your mortgage term going toward interest. As the loan amortizes, more and more of the mortgage payment goes toward the principal and less toward its interest.

Read on:

• Knowing your mortgage interest rate
• Fixed-rate mortgages
• Adjustable-rate mortgages (ARMs)
• Compounding interest
• Amortization
• Discount points

Knowing your mortgage interest rate

Before you even apply for a mortgage, you have to get preapproved. That means going to your bank, telling them you have the intent to buy a home, and submitting some basic information about your credit and finances. Once you’re preapproved, you’ll get a loan estimate document, which, in addition to your mortgage amount and any up-front costs, will also list your estimated interest rate.

Preapproval is the first step. After you lock down a home you like, you need to get approved. Before the mortgage is official, you’ll receive a closing disclosure, which lists your actual mortgage amount and interest rate. Once you sign, these become what you have to pay.

Fixed-rate mortgages

With a fixed-rate mortgage, your interest rate stays the same throughout the life of the mortgage. (Mortgages usually last for 15 or 30 years, and payments must be made monthly.) While this means that your interest rate can never go up, it also means that it could be higher on average than an adjustable-rate mortgage over time.

Adjustable-rate mortgages (ARMs)

The interest rate of an adjustable-rate mortgage (ARM) can fluctuate, depending on market trends. However, you usually get a certain number of years at the beginning of the loan period during which the interest rate is fixed. For example, if you have a 7/1 ARM, you get seven years at the fixed rate after which the rate can be adjusted once per year. This means your monthly mortgage payment could go up or down to account for changes to the interest rate.

Compounding interest

Every month, the unpaid interest accrues to your mortgage balance. Say you took out a mortgage for $200,000 with an interest rate of 4.5% and a term of 30 years. You’re not actually paying just 4.5% of $200,000 as interest; you’re paying interest on what remains of the balance after each payment each month. Because your monthly payment is only a small fraction of the total amount you owe, only a tiny part of the loan balance gets paid off, and interest gets charged again on that balance the next month.

Amortization

The process of making mortgage payments to reduce both your principal and interest until both are 0 is called amortization. Your mortgage payment is the same every month unless your interest rate changes, but the parts of your mortgage payment that goes toward your principal and interest charges changes the longer you have the mortgage. Interest payments are front-loaded early on and are gradually reduced until principal payments start to exceed them.

Lenders use an amortization table to show you exactly what you’ll pay against the principal and interest each month. A sample amortization schedule, using the example of the $200,000, 30-year, fixed-rate mortgage with 4.5% interest above, should look like this:

That same mortgage loan, but as an adjustable-rate mortgage that starts at 3.5% and goes up to 4.8% after seven years, has an amortization table that should look like this:

Discount points

Discount points, often just shortened to “points”, can be purchased when you first close on the loan. Each point costs a certain percentage of your mortgage amount but is worth a certain percentage off your annual interest payments. That means if purchasing one point costs 1% of your $200,000 mortgage, it will cost you an additional $2,000 on closing.

How much each point shaves off your interest rate is up to the lender. Before you decide to purchase points, make sure you see how your interest rate would change each month. For example, one point could be equal to a 0.25% reduction in your interest rate.

Using our $200,000 fixed-rate, 30-year-old mortgage with a 4.5% interest rate as an example, let's say your lender lets you buy one point for $2,000 and each point is worth 0.25% off. Your interest rate goes from 4.5% to 4.25%, saving you around $41 per month. However, that means it could take around four years to break even on your $2,000 costs.

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