How Does Interest on Home Loans Work?

When you buy a home with a mortgage loan, you pay back the principal along with interest on the amount you haven’t yet repaid. The interest you pay is the cost of borrowing funds. The interest rate you qualify for will depend on a number of factors, such as your down payment, credit score, and income.

How does interest on home loans work? It’s helpful to understand how interest on different types of mortgages works before you take out a loan, the components of your monthly payment, and the steps you can take to get the lowest possible rates.

What is Interest on Home Loans, and How Is It Calculated?

The interest on home loans is the price you pay for the privilege of borrowing money, aka, your home mortgage loan’s “principal”, from a lender to purchase your home. The interest rate you qualify for is expressed as a percentage rate and will determine how much you’ll pay to the lender.

Understanding how interest on home loans works is an important step in the home-buying process because it allows you to understand what the loan will cost you. Your monthly payments, which typically remain the same fixed dollar amount per month during the entire 10-30-year term of your mortgage loan, will be based on the loan’s amortization schedule. 

Initially, nearly all of your payment will go to the loan’s interest, at the beginning of your loan. As the loan matures, more of your monthly payment goes towards the principal until the last 1-2 years of your loan, when nearly all of your payment goes toward your loan’s principal balance.

Let’s say you’re buying a home for $500,000 with 20% down. You’re borrowing a 30-year mortgage of $400,000 (your loan’s principal) at a fixed interest rate of 5.27% per year. Your monthly payments, if you don’t sell your home, refinance your loan, or pay it off early, will be $2,214 each month for the entire 30 years of your mortgage loan. You can use a mortgage calculator to estimate your monthly payments and get an amortization schedule, which will show you how your home loan will be paid down over time.

Here’s what the first 12 months of your amortization schedule will look like considering the above information:

How Does Interest on Home Loans Work for Different Loan Types?

Before you take out a mortgage, you’ll need to decide which type of home loan you want. Here’s how the interest on home loans works for different types of loans.

Fixed-Rate Mortgages

When you borrow a fixed-rate loan, your interest rate will remain the same throughout the loan term. This means that your monthly payment will also stay the same. Let’s say you borrow a loan amount of $400,000 for 30 years at a fixed rate of 5.27%. You’d pay a monthly installment of $2,214 for the entire 30 years.

Adjustable-Rate Mortgages

With an adjustable-rate mortgage (ARM), your interest rate will change based on market conditions. Your mortgage may come with a lower introductory rate for the first several (i.e. 2 to 7) years, after which the rate changes, resetting each year, on your loan’s anniversary date, according to some interest rate index (e.g. the Fed Funds rate or the current yield on the 10-year U.S. Treasury Note). This can also decrease or increase your monthly payment.

Jumbo Loans

Jumbo loans are larger loans exceeding the local limits set by the Federal Housing Finance Agency (FHFA). The mortgage requirements for jumbo loans are usually stricter than those for conventional loans.

Jumbo loans can be adjustable or fixed, but they usually have a higher interest rate than those of smaller loans. You may also be able to get an interest-only jumbo loan with an interest-only period. After that, the interest rate will adjust annually, and the payments will begin going toward reducing the loan’s principal.

What Is Included in a Monthly Home Loan Payment?

Your monthly home loan payment will typically be made up of four components, as we’ve listed below. Keep in mind that you may opt for home loans that don’t include home insurance or property taxes as a part of your monthly payment. Instead, you can pay them separately.

Principal

A portion of each payment you make goes towards the repayment of the principal you borrowed. The amount of loan that goes to the principal starts out low and increases as you make more payments.

Interest 

This is what you’ll pay to the lender for borrowing the money. Your interest rate will decide how small or large your mortgage payment will be. During the initial years, the interest portion of your payments will be higher. This interest portion of your payment will gradually decrease as you make more mortgage payments, and more and more of your payment will go toward reducing your principal balance.

Taxes

Local government agencies assess property taxes on an annual basis. However, you can choose to pay them as a part of your monthly mortgage payments. The lender can collect the property tax payments and hold them until they need to be paid.

Insurance 

There are two types of insurance payments that may be included in your mortgage payment. Homeowners insurance protects your home and its contents from theft, fire, and natural disasters. You may also have to pay private mortgage insurance (PMI) if your down payment is less than 20%.

Paying your property taxes, PMI, and home insurance in monthly installments, along with your mortgage loan payment, is referred to as paying via mortgage escrow.

What’s the Difference Between APR and Interest Rate?

The interest rate on a mortgage only accounts for the cost of borrowing money from the lender. The annual percentage rate (APR) includes the interest rate as well as other costs, such as origination fees, document processing fees, annual loan maintenance fees, and the like. APR is always higher than the loan’s interest rate because it includes these additional charges.

APR is the actual total cost you pay for borrowing the money that is lent to you, with everything included, and lenders are required by law to disclose it so borrowers have this information upfront, and can compare it on an “apples to apples” basis with other fixed or adjustable mortgage loans they may qualify for. Keep in mind that what’s included in an APR can differ for each lender, so it’s important to ask what it includes when you’re comparing loan offers.

How To Get a Lower Interest Rate on a Home Loan?

An interest rate that’s lower, even by a few points, can help you save thousands of dollars over the life of the loan. Here are a few things you can do to get a lower rate on your home loan:

• The best way for a homebuyer to get the lowest mortgage rate is by shopping around and comparing rates.
• Once you have a few loan offers in hand, negotiate to see if they can beat the best mortgage rate you have.
• Work with a mortgage broker to negotiate on your behalf. They usually have a large list of contacts which they do business with frequently, and may be able to get you a better deal.
• Take the time to improve your credit score before you start the home purchase process. Pay your bills on time, avoid taking on new debt, and pay down your existing debt to improve your debt-to-income ratio.
• Save a larger down payment because it can help you negotiate a lower mortgage interest rate.

Understand How Interest Rates on Home Loans Work Before You Borrow

A mortgage can be an essential tool for buying a house, but it’s also important to understand how your payments are structured, how interest on home loans work, what an amortization schedule is, and what’s included in your monthly payments.

Use a mortgage calculator to see how much you’ll pay in total interest over the term of your mortgage loan, what your monthly payments look like, and if it’s affordable for you.