How does mortgage interest work?

What is mortgage interest?

When you take out a mortgage to buy a home, you’ll have to pay interest to the institution lending you money. Interest is a fee that helps offset the risk the lender takes when letting you borrow their funds.

Your monthly payment includes the original loan amount (the principal) and interest. At the beginning of your mortgage, your payments mostly go toward the interest on your loan. However, as time goes on, your balance decreases, and you start paying more on the principal and less on interest.

Depending on the situation, there may be some tax deductions for homeowners, such as the interest they pay on their mortgage. However, you can only take advantage of a mortgage interest deduction if you’re not already taking the standard deduction on your return.

How is mortgage interest calculated?

Your lender will create a payment schedule using an amortization formula that divides your principal and interest into monthly payments.

The lender applies the interest, expressed as a percentage, to your outstanding principal. Your interest rate directly influences your monthly payment amount and the total amount you will pay for your home by the end of the mortgage.

Mortgages have compounding interest, meaning you pay on the principal and any previously accrued interest. The more frequent the compounding, the more interest you will pay.

» MORE: Principal vs. interest: What’s the difference?

Factors that affect mortgage interest rates

While several factors can influence your mortgage’s interest rate, here are some of the main ones to watch out for:

• Credit score: Borrowers with higher credit scores can typically secure better mortgage rates.
• Down payment: A larger down payment often results in a lower interest rate.
• Loan term: Loans with shorter terms, such as a 15-year mortgage, often provide lower rates. However, the monthly payments are typically lower with lengthier mortgages, so they may be more manageable.
• Loan type: If you choose an adjustable-rate mortgage (ARM) vs. a fixed-rate mortgage, you may get a lower interest rate at the beginning of the loan. However, once the introductory period ends, your interest rate can change, and you may pay a higher rate.
• Market conditions: Lenders often set the interest rates according to the federal funds rate. Whether the Fed cuts or raises the benchmark interest rate depends on economic indicators such as inflation, unemployment and gross domestic product (GDP).

How to lower your mortgage interest

Although some factors, such as market conditions, may be out of your control, there are some ways to get a low mortgage rate:

• Improve your credit score: Lenders typically offer the best interest rates to borrowers with very good or excellent credit scores (between 740 and 850).
• Save for a bigger down payment: While lenders frequently only require 3% to 5%, a larger down payment can lower your interest rate because you're borrowing less money.
• Compare rates at different lenders: Interest rates often vary between mortgage lenders; requesting quotes from multiple institutions can help you find the best rate.
• Look into an FHA loan: If you have a low credit score, you may qualify for a lower rate through an FHA loan.

You may also be able to refinance for a lower interest rate a few years into your mortgage. However, refinancing does come with its own closing costs, so you’ll have to weigh whether it’s a good strategy for your situation.

The impact of extra payments on interest

“With mortgage rates on the rise, many people are looking at paying off their mortgage faster,” said Jay Zigmont, a certified financial planner and founder and CEO of Childfree Wealth, a financial planning firm for people without children. “If your mortgage rate is 4% or more, this is a good idea.”

According to Zigmont, even though high-yield savings accounts are paying competitive rates right now, you have to pay taxes on any interest you earn. Meanwhile, making extra mortgage payments is tax-free and risk-free.

“When paying down your mortgage, your best bet is to make extra principal payments,” said Zigmont. “When you pay down the principal, it lowers the amount going to interest with future payments. You may be able to automate your extra principal payments by adding on money to your monthly payment.”

Zigmont also suggested making biweekly payments to increase the amount you put toward your mortgage each year.

Example of how extra payments affect interest

Let’s look at an example of how paying just $200 extra on your mortgage can affect the total amount paid.

The following chart illustrates a 15-year mortgage with an original balance of $200,000 and an interest rate of 7%.

As you can see, paying an extra $200 on your mortgage each month results in a shorter payoff schedule and lower total costs than if you had only paid the regular monthly payments.

In total, you would save $22,330 and pay off the loan two years and five months early.

» MORE: Mortgage APR vs. interest rate

Bottom line

Your monthly mortgage payment consists of both the amount you borrowed (the principal) plus interest. Interest is the amount the lender charges for taking on the risk of lending you money.

While some factors that influence mortgage rates are outside your control, you may get a lower rate if you improve your credit score, increase your down payment and compare different lenders.

Furthermore, you can minimize how much interest you pay over the course of your loan by contributing extra payments toward your principal each month.