How Do Mortgage Interest Rates Work

Whats Behind Your Mortgage Rate

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Buying a home is probably the biggest purchase youll ever make. If youre like most people, you wont pay cashyoull borrow most of the money by taking out a mortgage. And over the life of the mortgage, youll pay a lot in interest.

Small changes in interest rates can make a big difference in how much youll pay. So its important that you understand what determines the interest rate on your mortgage, even if you already own a home.

Many factors go into the interest rate you pay.

Home Price And Loan Amount

Homebuyers can pay higher interest rates on loans that are particularly small or large. The amount youll need to borrow for your mortgage loan is the homeprice plus closing costs minus your down payment. Depending on your circumstances or mortgage loan type, your closing costs and mortgage insurance may be included in the amount of your mortgage loan, too.

If youve already started shopping for homes, you may have an idea of the price range of the home you hope to buy. If youre just getting started, real estate websites can help you get a sense of typical prices in the neighborhoods youre interested in.

Enter different home prices and down payment information into the Explore Interest Rates tool to see how it affects interest rates in your area.

Why Its Important To Shop For Multiple Quotes

When youre getting a mortgage, its important to compare offers from a variety of lenders. Every lender will evaluate your financial situation differently. So getting multiple quotes will allow you to choose the offer with the best rate and fees. The rate difference between the highest and lowest rates lenders offer you could be as high as 0.75%, according to a report by the fintech startup Haus.

However, the interest rate isnt the only factor you need to consider when comparing mortgage lenders. The fees each lender charges can vary just as much as the interest rate. So the offer with the lowest rate may not be the best deal if youre paying excessive upfront fees. To compare rates and fees, take a look at the Loan Estimate form that lenders are required to provide within three business days of receiving your application. The Loan Estimate is a standardized form, which makes it easy to compare quotes.

You can visit NextAdvisors comprehensive list of mortgage lender reviews here.

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Fixed Payments With A Variable Interest Rate

If the interest rate goes up, more of your payment goes towards the interest, and less to the principal.

If the interest rate goes down, more of your payment goes towards to the principal. This means, you pay off your mortgage faster.

If the market interest rates increase to a certain percentage or trigger point, your lender may increase your payments. This payment increase will make sure that you pay off your mortgage by the end of the amortization period. The trigger point is listed in your mortgage contract.

A Summary Of Different Interest Rates

There are many other types of interest rates and loan products. When it comes to setting rates, certain loans, such as residential home mortgage loans, may not be based on the prime rate but rather on the U.S. Treasury Bill rate , the London Interbank Offered Rate , and longer-term U.S. Treasury bonds.

As rates on these benchmarks rise, so do the rates that banks charge. Other loans and rates include government-backed loans such as mortgage-backed securities , student loans, and small business loan rates , the last of which are partially backed by the government.

When the government has your back, loan rates tend to be lower and are used as the basis for other loans made to consumers and businesses. Of course, this can lead to reckless lending and moral hazards when borrowers assume the government will bail them out when a loan goes bad.

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Don’t Focus Only On The Rates

When shopping with multiple lenders, consider the total cost of the loan, not just the interest rate. Closing costs run between 2% to 5% of your loan. They are divided into three basic parts.

Fixed Interest Rate Mortgage

Fixed interest rates stay the same for your entire term. They are usually higher than variable interest rates.

A fixed interest rate mortgage may be better for you if you want to:

• keep your payments the same over the term of your mortgage
• know in advance how much principal youll pay by the end of your term
• keep your interest rate the same because you think market interest rates will go up

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What Is Mortgage Interest

Mortgage interest is a fee you pay to a lender for the use of their money. When you first start making mortgage payments, most of your funds go toward interest. Then, as you approach the end of your mortgage, much of the money is applied toward the principal loan.

Every lender has different interest rate options. For example, you can choose between a fixed rate or a variable rate when you get a mortgage. With fixed-rate mortgages, your interest rate doesnt change during the term of the mortgage. On the other hand, variable-rate mortgages can fluctuate.

When your mortgage is up for renewal, you will renegotiate the term and interest rate.

Mortgage Interest Rate Vs Annual Percentage Rate

Your annual percentage rate is a more complete picture of how much it costs you to borrow.

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What Are The Disadvantages Of Paying Off Your Mortgage

Cons of Paying Your Mortgage Off Early You Lose Liquidity Paying Off Your Mortgage. Liquidity refers to how easy it is to access and spend the money you have. You Lose Access to Tax Deductions on Interest Payments. You Could Get a Small Knock on Your Credit Score. You Cannot Put The Money Towards Other Investments.

Final Thoughts On Mortgage Refinance

If youve reviewed your financial goals and decided its the right time to refinance, your next step is to find the best mortgage refinance lenders.

There are some other things you should do, too:

• Know what your home is worth

The internets estimate of your homes value isnt always accurate. You should learn the fair market value as reported by your local tax commissioner. Its also a good idea to get a sense of how much other homes in your neighborhood are worththat plays a role in your own homes value.

• Protect your credit score

Make your payments on time, pay off debts, and make any other positive financial changes you can.

• Get your home ready for an appraisal

Your house is likely to be appraised as part of the refinance process. You may want to make some changes to your home, such as repainting and cleaning your basement.

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How Occupancy Affects Mortgage Rates

Another factor that really plays into your mortgage rate is how you plan to occupy the property. Is it a primary home, second or vacation home, or an investment property?

You get the lowest rate on a primary property, while rates may be slightly higher for a vacation home and slightly higher again for an investment property. This again goes back to risk.

If you get into financial trouble, youre going to make the payment on your primary property before you would make one on your second home. Similarly, you may make the payments on your vacation home before you make it on a rental property that you dont live in and have an attachment to beyond collecting rent.

Hybrid Or Combination Mortgages

You could choose to opt for a hybrid or combination mortgage. In these mortgages, part of your interest rate is fixed and the other is variable.

The fixed portion gives you partial protection in case interest rates go up. The variable portion provides partial benefits if rates fall.

Each portion may have different terms. This means hybrid mortgages may be harder to transfer to another lender.

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What’s The Difference Between A Mortgage Rate And Apr

Your mortgage rate is one component of the figure that makes up your annual percentage rate . For this reason, your .

Your mortgage interest rate only covers the cost of borrowing a specific amount of money from a lender and is the actual rate used to calculate your monthly principal and interest payment The APR covers a broader spectrum of the costs involved in a mortgage, including:

• Broker fees
• Discount points
• A portion of your closing costs expressed as a percentage

When comparing APRs for different loans, it’s important to ask your lender what’s included in your APR and how the terms of your loan affect the amount.

How The Bond Market Affects Mortgage Rates

We dont tend to think of it this way because home is so personal for everyone, but at the end of the day, mortgages are just a big financial instrument. Like a lot of finance products, mortgages can be traded among investors. The particular mechanism for trading home loans is the mortgage bond.

Also called mortgage-backed securities , mortgage bonds are collections of loans with similar characteristics such as down payment amount, credit score and the original investor in the loan .

Based on your personal characteristics, you get bucketed into an MBS. Investors who are choosing bonds make decisions about which bonds to buy based on their risk tolerance and desire for a certain rate of return.

If you fall into a category with better financial characteristics, youre more likely to be able to make your payment than someone who has a riskier profile. The trade-off is that the interest rate is lower for you than it would be for the other borrower.

However, it goes beyond personal factors. One of the key things to understand is that the bond market in general is considered to be a safer place to put your money than the stock market. Although the stock market may offer a higher rate of return, its subject to a lot more volatility and could suffer more in a downturn. Bonds offer a guaranteed yield.

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Fixed Versus Adjustable Interest Rates

A mortgage on which the interest rate is set for the life of the loan is called a fixed-rate mortgage or FRM, while a mortgage on which the rate can change is an adjustable rate mortgage or ARM. ARMs always have a fixed rate period at the beginning, which can range from 6 months to 10 years. The rate adjustment feature of an ARM makes it a lot more complicated than an FRM, which is why many borrowers wont consider an ARM.

Using Apr To Compare Mortgage Offers

Comparing APRs is not the best way to evaluate mortgage offers. Instead, its more useful as a regulatory tool to protect consumers against misleading advertising.

Federal Regulation Z, the Truth in Lending Act, requires lenders to disclose a loans APR when they advertise its interest rate. As a result, when youre checking out lenders websites to see who might give you the best interest rate, youll be able to tell from looking at the APR if the lender with the great interest rate is going to charge you a bunch of fees, making the deal not so great after all.

Page 3 of the loan estimate that lenders are required to give you when you apply for a mortgage shows the loans APR. By comparing loan estimates , you can easily compare APRs.

Still, most borrowers shouldnt use APRs as a comparison tool because most of us dont get a single mortgage and keep it until its paid off. Instead, we sell or refinance our homes every few years and end up with a different mortgage.

If youre looking at two loans and one has a lower interest rate but higher fees, and the other has a higher interest rate but lower fees, you might discover that the loan with the higher APR is actually less expensive if youre keeping the loan for a shorter term, as the table below illustrates.

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What Are Federal Reserve Interest Rates

The Federal Reserve Bank, or Fed, is the central bank in the United States. This bank sets what is called the federal funds rate, a rate one bank will charge another bank for quick, overnight loans needed to meet their legal reserve mandates.

The Fed also sets the federal discount rate, which is interest the Fed charges banks when they borrow from the Federal Reserve itself.

These Federal Reserve rates impact the rates that banks charge for loan products.

Generally, the Federal Reserve will raise interest rates in good economic times, and lower them when the country is facing recessions. Low rates encourage consumers to spend rather than save, thereby re-boosting a receding economy. The rates are meant to help control inflation.

Lenders will raise and lower their rates to match the Federal Reserve. An example of loans that will be affected by Federal Reserve rates include:

• Auto loans
• Savings accounts
• Certificates of Deposits

One interest rate that isnt directly affected by the Fed is your mortgage rate. Mortgage rates are affected by investors who buy bonds and mortgage-backed securities. Although a federal hike may have a small impact on mortgage rates, experts generally look to other factors.

What Is A Good Mortgage Rate

Mortgage rates fluctuate frequently, so whats considered good changes over time. While its a smart idea to compare mortgage rates online, youll also need to compare quotes specifically tailored to your situation in order to find a good rate. One rule of thumb is to get at least three offers so you know what rates are available based on your credit and financial profile.

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Fixed Vs Adjustable Interest Rates

Mortgage interest rates in the United States are currently running between 2% and 4%.

If you have a fixed-rate mortgage, you never have to worry about it changing. Your interest rate will remain the same for the whole life of your loan. You will always know exactly what you owe on your loan every month. The lowest-cost mortgage loans are fixed-rate loans at a low-interest rate.

An adjustable-rate mortgage is different. Your interest rate changes over time. It usually starts with a fixed rate. After a certain amount of time passes, the lender can adjust the rate. The change in rates is based on an index rate that is defined by the finance industry. The lender adds a certain amount of profit on top of that.

Adjustable-rate mortgages can be unpredictable. Often adjustable-rate mortgages start with a lower rate than fixed-rate mortgages, but theres no guarantee the rate will stay low. If interest rates are going down in the economy, you will pay less. If they are going up, you will pay more. There is no way to predict this in advance. The economy can change a lot in five years! So, the rates can go up or down.

When Mortgage Payments Start

The first mortgage payment is due one full month after the last day of the month in which the home purchase closed. Unlike rent, due on the first day of the month for that month, mortgage payments are paid in arrears, on the first day of the month but for the previous month.

Say a closing occurs on January 25. The closing costs will include the accrued interest until the end of January. The first full mortgage payment, which is for the month of February, is then due March 1.

As an example, lets assume you take an initial mortgage of $240,000, on a $300,000 purchase with a 20% down payment. Your monthly payment works out to $1,077.71 under a 30-year fixed-rate mortgage with a 3.5% interest rate. This calculation only includes principal and interest but does not include property taxes and insurance.

Your daily interest is $23.01. This is calculated by first multiplying the $240,000 loan by the 3.5% interest rate, then dividing by 365. If the mortgage closes on January 25, you owe $161.10 for the seven days of accrued interest for the remainder of the month. The next monthly payment, which is the full monthly payment of $1,077.71, is due on March 1 and covers the February mortgage payment.

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Beyond Rates What Else Matters When You Shop For A Mortgage

Every good mortgage provides options for paying down your principal amount faster. Taking advantage of these flexible features may have a greater impact on your cost of borrowing than simply choosing the lowest interest rate.

Heres an overview:

As you can see, theres more to a great mortgage than just the interest rate. Flexible features that let you pay off your mortgage faster, for less, can be just as valuable. Get the whole picture from a Mortgage Specialist at Meridian today. And because we are provincially regulated, we have extra flexibility to create personalized mortgage solutions for our Members.