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It’s also one of the biggest financial decisions of your life. But before rushing into any big decision, it’s important to understand all the factors at play. This includes learning how mortgage interest works.
By understanding how mortgage interest is calculated, you’ll be able to choose the loan-type that is best suited for you (and hopefully save you some money in the process).
Let’s get started.
What determines the amount of mortgage interest you pay?
When you take out a home loan, several factors determine how much interest you’ll pay. It’s important to understand these factors before locking yourself into any agreements.
Mortgage interest rate
Simply put, your mortgage interest rate is the cost of borrowing money from a mortgage lender. Your interest rate will depend on several factors including your creditworthiness, your loan type, the federal funds rate and more.
While small differences in rates may not seem like a big deal, they can make a significant impact on the total amount of interest you will pay over the length of a 30-year loan.
Federal funds rate
The federal funds rate is set by the Federal Reserve and influences the rates at which banks lend money. If you have an adjustable-rate mortgage (ARM), changes in the federal funds rate could affect your interest payments.
How much you borrow
The more you borrow, the more interest you’ll end up paying. For example, if you borrow $10,000 at 3% interest, it will cost you only $300. But if you borrow $100,000 at 3%, you’ll pay $3,000 in interest.
Outstanding loan amount
Your interest payment is calculated using the outstanding amount on your loan. When you take out a mortgage, your interest payments will be highest during the first year of your loan and gradually decrease as your balance is paid off.
Loan term
The faster you pay off your loan, the less you’ll pay in interest. Also, since shorter loans are less risky for lenders, you’ll typically find that 15-year mortgages have lower interest rates than 30-year mortgages.
More: Mortgage affordability calculator
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How is mortgage interest calculated?
While mortgage loans come in many shapes and sizes, most fall into one of two categories: fixed-rate mortgages and adjustable-rate mortgages (ARMs). The total mortgage interest you pay will vary based on the type of loan you have.
Fixed-rate mortgage
Just like it sounds, with a fixed-rate mortgage, the interest rate and monthly payments stay the same for the entire life of the loan.
Fixed-rate mortgages typically last for 30 years, but if you want to pay less interest (and can afford the higher monthly payments) you can find 10-, 15-, and 20-year mortgages as well.
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Interest payments on a fixed-rate mortgage are generally calculated every month by multiplying your loan balance by your interest rate, then dividing by 12.
For example, if you take out a $200,000 loan with a 3% interest rate, your monthly payments will be around $1,050. Here’s how much of that $1,050 will go towards interest on your first payment:
$200,000 multiplied by 0.03, divided by 12, equals $500 in interest.
So, for your first mortgage payment, $500 will go towards interest, and $550 will go towards paying off the principal.
Each month, your interest payment will be re-calculated using your new, lower balance.
In month two, you’ll pay $498.75 in interest and $551.25 towards the principal.
Each month, your interest payment will be re-calculated using your new, lower balance.
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In month two, you’ll pay $498.75 in interest and $551.25 towards the principal.
In month three, you’ll pay $497.25 in interest and $552.63 towards the principal.
And so on.
Adjustable-rate mortgage
With an ARM, your interest rate is not fixed, which means your monthly payments can fluctuate over time.
Oftentimes, ARMs come with a discounted rate for a set amount of time. After that, they are periodically recalculated based on different financial indexes.
ARMs are a lot more complicated than fixed-rate mortgages, and you have to be careful to thoroughly read through and understand all the terms and conditions — especially those related to adjustment periods, interest caps and financial indexes.
The way you calculate interest on an adjustable-rate mortgage is the same as a fixed-rate mortgage — loan balance multiplied by interest rate, divided by 12. The only difference is that your lender will re-calculate your interest rate every so often. This adjustment period could range from every quarter to every five years.
Principal and interest vs. interest-only payments
Most people make principal and interest payments on their mortgage. This means that part of your monthly mortgage payment covers your interest, and the rest goes towards chipping away your principal.
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However, in certain situations it may make more sense to take out an interest-only mortgage.
With an interest-only mortgage, you have a smaller monthly payment that goes entirely towards paying interest. Unless you choose to make additional payments, you will not pay down the mortgage (at least not for the first several years).
These types of loans are riskier, more difficult to get approved, and make more sense in unique circumstances, such as:
- You’re confident you’ll have a substantial bump in income in the next couple years (e.g., you’re a med student).
- You have an inconsistent income where it’s easier to pay off your principal in less frequent chunks.
- You are wealthy and feel you can get a better return on your money investing it elsewhere.
As you can see, an interest-only mortgage can be a useful tool in certain situations. But for most people, making principal and interest payments is the way to go.
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How to calculate mortgage interest
To calculate mortgage interest, you will need three numbers:
- Your loan balance.
- Your interest rate.
- Your monthly payment amount (find your estimated monthly payment using this calculator.
As you can see, your mortgage interest rate has a huge impact on how much interest you will pay over the course of your loan. That’s why, when purchasing a home, it’s vitally important to take the time to shop around for the best interest rates.
Loan shopping is nowhere near as fun as touring new homes and neighborhoods, but with a little extra effort, it could save you a lot.
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Mitchell is a freelance contributor to Moneywise.com.
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