How Do Interest Rates Work?

Although we may not like it, loans come with interest, and that includes mortgages. While this is unavoidable when securing a mortgage loan, understanding how interest rates work can help you determine the type of loan that is best for your situation. 

Banks and lenders offer two primary types of loans: fixed-rate and adjustable-rate. Let’s explore the differences between the two. 

Fixed-Rate Mortgages

In a fixed-rate mortgage, the interest rate does not change. Therefore, the monthly payments will be the same over the entire life of the loan. Most loans have a 30-year repayment period, although shorter loan periods are available. Shorter loan terms come with higher monthly payments, but the interest rate and the total amount of your payments will be lower. 

Your annual loan interest rate will be divided by 12 to get your monthly interest payment. If your annual interest rate is 4%, your monthly interest rate is 0.3%. Take this example:

Loan Amount: $180,000

Loan Period: 30 years

Monthly Payment before Interest: $500 

Annual Interest: 4%

Monthly Interest: 0.3%

Monthly Mortgage Payment: $650

Part of your monthly payment goes toward paying off the principal, or mortgage balance, but a significant portion goes toward interest on the loan. With each passing month, the principal gets a little smaller, meaning the percentage of your payment that goes to interest gets smaller. 

Adjustable-Rate Mortgages

With an adjustable-rate mortgage, the interest rate can fluctuate, allowing the monthly payment to change over time. While this inconsistency can cause hesitation, most adjustable-rate mortgages limit how high the interest rate can go and how often it can change. Your monthly payment will recalculate every time the rate goes up or down. 

These rates usually start significantly lower than rates on fixed-rate mortgages, and they are guaranteed to last for the first few years. This benefits individuals who do not plan to live in the home longer than the rate is guaranteed. 

What Affects Mortgage Interest Rates?

Several factors affect mortgage interest rates, including inflation and monetary policy. Inflation is an estimate of the change in the value of the dollar. $1 buys more today than it will ten years from now, so lenders charge interest to cover the cost of inflation while earning a profit. The Federal Reserve’s monetary policies also have effects throughout the economy, including interest rates. Mortgage lenders monitor these factors and adjust rates accordingly. 

Another factor that affects interest rates is supply and demand. Downward pressure on interest rates increases when demand for homes decreases as more people opt to rent. 

Those outside environmental factors affect the market rates, but your financial history and credit score significantly affect the individualized interest rate you will receive. 

The good news is that mortgage rates are some of the lowest they have ever been, although they won’t stay that way forever. 

How Will Interest Rates Affect My Mortgage Payment?

To get an idea of how much your payment will be each month, try our free mortgage calculator! While many factors affect your monthly payment, this tool will give you the insight you need to get started.

If you’re ready for a quote or preapproval, visit our homepage for thee resources, or email us at contact@MortgageRight.com to lock in a low mortgage rate today! 

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