How does interest work on a mortgage: A homeowners’ guide

When you’re buying a home, the listing price is only part of the story. The interest on your mortgage plays just as big a role, shaping the total cost of the loan, your monthly payment, and how fast you build equity. 

Interest can be the difference between a manageable and overwhelming expense.

In this article, we’ll break down how interest works on a mortgage to give you a clearer picture of your home’s real cost. 

...in as little as 3 minutes – no credit impact

What’s mortgage interest, and how does it work?

Interest payments on a mortgage refer to the cost you pay to borrow money from a lender. When you first buy a home, most of your monthly payment goes toward interest. As you pay down the loan, more goes toward the principal (the amount you borrowed). 

Here’s a quick mortgage rate example to show how that works: 

Say you buy a $300,000 home at 6 percent interest and put $60,000 down. In total, you’d borrow $240,000 from the lender, and your monthly payments would be around $1,439. 

When you still owe $240,000, the first month’s interest would make up $1,200 of that monthly payment. The remaining $239 would go toward the principal. 

That balance shifts over time. Once you owe $100,000, only $500 a month would go toward interest. Lenders lay this out in an amortization schedule, which shows how they apply your payments throughout the life of the loan.

This system is the foundation for how interest on a home loan works. It ensures the financial institution gets compensated for taking on the risk of lending you money while also giving you a clear path to paying off the loan.

What’s the mortgage interest rate based on?

The following factors can affect your mortgage rates.

Credit score

Lenders look at your credit score to get a sense of how you’ve handled money in the past. A higher score signals less risk for the lender and can help you qualify for a lower rate. If your score is lower, the rate may be higher.

Down payment

Providing a larger down payment can encourage lenders to give you a lower interest rate. It shows you’re able to budget and save well, plus it means you’ll need to borrow less overall. This makes your loan less of a risk for the financial institution.

Market conditions

Economic shifts, inflation, and lending policies all influence interest rates. Even if your finances look great, application timing can affect your bottom line.

Loan details

Your loan structure may also impact the rate as well as its effect on your monthly payments. A shorter repayment term can be priced differently than a longer one, and fixed or adjustable loans each come with their own approach to interest. You can see how these choices affect the final number in your mortgage price.

Different ways mortgage interest works

Mortgage interest isn’t handled the same way for every loan. Lenders offer different structures, and each one changes how your payments are set up. Below are the most common options.

Fixed-rate mortgage

With a fixed-rate mortgage, the interest rate you agree to on day one doesn’t change. Your monthly principal and interest stay ready for the entire loan term, which can make budgeting easier.

Adjustable-rate mortgage

An adjustable-rate mortgage (ARM) begins with a fixed rate for a certain number of years. After that, the rate adjusts at set intervals based on an index and preset margin. Your payment could rise or fall depending on the market. ARMs usually come with limits, called caps, so the changes don’t happen all at once.

Interest-only mortgage

With an interest-only mortgage, your initial payments cover just the interest. This makes those early payments smaller, but the principal balance doesn’t go down. Once the interest-only period ends, the payment increases because you then start paying both interest and principal together.

Government-backed loans

The government offers several alternative types of loans, often with lower interest rates. Below are a few examples: 

— USDA loans: The U.S. Department of Agriculture (USDA) offers these loans to buyers looking to settle down in rural areas. The USDA sets interest rates for low and very low-income borrowers each year. They also offer payment assistance, which can lower interest to as little as 1%.

— FHA loans: The Federal Housing Administration (FHA) offers these loans, often to buyers with lower credit scores. Interest rates tend to be lower than conventional loans, but you may be on the hook for more fees.

— VA loans: Eligible members of the U.S. military and surviving spouses qualify for these loans. Rates are often lower than conventional and FHA mortgages.

How can I lower interest rates on a mortgage?

If you’re looking to reduce your rates, consider the following strategies:

— Negotiate: Some lenders are willing to talk through the rate, especially if you have strong credit or other offers to compare. Shopping around and asking questions can sometimes give you an edge.

— Refinance: Swapping your current loan for a new one could help lower both your rate and your monthly payment. Try the refinance calculator and check today’s rates to see what kind of difference this might make.

— Modify your rate: In certain cases, lenders may offer programs that let you adjust the terms of your existing loan. This could mean reducing the rate through a modification or finding another way to ease the overall interest cost.

Understanding the home mortgage interest deduction

The home mortgage interest deduction is a tax break that lets some homeowners write off the interest they’ve paid on their loan. It won’t shrink your monthly payment, but it can ease your tax bill by reducing the income you’re taxed on.

Say you pay $8,000 in interest over the course of a year, and your income tax rate is 22 percent. You’d be able to reduce your taxable income by $8,000, saving you $1,760 for the year. 

Before writing this off on your taxes, check the IRS website to see if you qualify. Limits and availability vary based on when you bought the home, whether you’re married, and how much you owe.

Also, only taxpayers who itemize their deductions can write off mortgage interest. Those who take the standard deduction can’t claim this deduction.

Find competitive interest rates with Better

Interest shapes your mortgage payment, total loan cost, and even your taxes. Knowing what affects your rate and how loans handle interest makes it easier to choose what works for you.

Better makes those decisions simpler. We offer fixed and adjustable-rate mortgages through a quick online application process, and approvals can happen in as little as three minutes. 

Even if you already own a home, Better can help with your interest. Use points to buy down your rate, and explore refinancing choices that can reduce long-term interest. 

...in as little as 3 minutes – no credit impact

FAQ

What’s considered a reasonable interest rate on a mortgage?

There isn’t one number that works for everyone. What feels reasonable depends on the market at the time and on your financial details, like credit and down payment. A rate that looks great for one borrower might not be the same for another, so comparing offers is the best way to see what’s fair for you.

How frequently do mortgage interest rates change?

Rates often change daily based on the economy and lender activity. If you want the most up-to-date picture, checking mortgage rate listings is the quickest way to see where things stand.

How much of my payment goes toward interest vs. principal?

The interest-to-principal ratio shifts over time. In the beginning, a larger share of your monthly payment usually goes toward interest. As the loan balance drops, more of each payment goes toward the principal instead. A mortgage calculator can show you exactly how the numbers look for your loan. This information will also be in your amortization schedule.