Understanding How Interest Rates Work on a Mortgage
Getting a mortgage is one of the largest financial transactions you will enter into. With a mortgage, a lender or bank will finance 80% of the home price and then you agree to pay this back with interest over a certain period. It’s important to know how interest accrues and how you pay it.
Mortgage Payment Calculation
When you pay your mortgage each month, you pay back some of the principal, which is the amount you borrow, and the interest each month. The lender uses an amortization formula in order to create a payment schedule that will break down each payment into interest and principal.
The length of the loan also plays into how much you will pay each month. If you stretch out payments over more years, it will usually result in lower monthly payments. The longer you pay it off, the higher the overall purchase of the home will be because you will be paying interest for a longer period.
A Conventional Mortgage and Adjustable Rate Versus Fixed Rate
A conventional mortgage will have either a fixed or adjustable rates. With fixed rates, the interest rate doesn’t change. With adjustable rates, the interest rate will change under certain conditions.
Fixed Rate Mortgage: Your monthly payment stays the same for the life of your loan. The interest rate is locked in and doesn’t change. Loans will have lengths of 10, 15, 20, or 30 years. Shorter loans have bigger monthly payments but a lower interest rate.
Adjustable Rate Mortgage: The interest rate isn’t locked in so the monthly payment changes over the life of the loan. Most have a cap or limit on how much the interest rate can change and how often it can change.
When the rate goes down or up, the lender then recalculates the payment and you make equal payments until the next rate adjustment happens. If interest rates rise, so do your payments.
Many times, lenders offer lower interest rates for the first few years of an ARM but rates will change after that, sometimes as often as once a year. If you plan on staying in a home for only a few years then this can be an attractive option.
Interest Only Loans
With this loan option, you will have the option to pay only the interest for a few years. This can be an attractive option for first-time buyers since there are lower payments during these years. Interest only jumbo loans are available but are usually reserved for the very wealthy.
These loans are structured similarly to an adjustable rate mortgage and the interest only period can last 10 years. After this, the rate adjusts yearly and payments go toward paying off principal, which means they can go up a lot.
Interest and Tax Deductions
If you are going to itemize deductions on your annual tax return then you are allowed to deduct interest payments toward your home mortgage. For a state return, the deduction will vary. Always check with a tax professional for the rules.