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How does mortgage interest work?

Mortgages come with different loan terms and interest rates. The term refers to the lifespan of the loan, which is usually between 15 and 30 years. The mortgage rate refers to the amount of interest the lender charges in exchange for the loan.

Mortgage rates can be fixed or adjustable. A fixed-rate mortgage has the same interest rate for the entire term, whereas an adjustable-rate mortgage increases or decreases based on a changing index. The most popular type of adjustable-rate mortgage is the 5/1 ARM, which has a fixed rate for the loan's first five years and then can adjust each year after that.

Mortgage rates and terms have the most impact on how much you’ll pay over the life of the loan.

What is a good mortgage interest rate?

With any mortgage loan, a lower interest rate is better. Depending on the type of loan you select, current interest rates are between 2% and 3%, with APR starting around 2.5%. A good fixed interest rate in 2021 is about 3% on a 30-year term or a little over 2% on a 15-year term. A good mortgage interest rate on an ARM is between 2.8% and 3%.

Mortgage interest rates vary from year to year. In general, rates tend to be higher when the economy is doing well. However, keep in mind that mortgage interest rates vary from lender to lender and also by state. Lenders often charge less interest when you promise to repay the principal in less time.

How to get the best mortgage rate

The easiest way to get the best interest rate is to compare multiple mortgage lenders and refinancing companies, according to the Consumer Financial Protection Bureau (CFPB). Other tips for getting a great mortgage deal include improving your credit, making a larger down payment, buying mortgage points and selecting an adjustable-rate mortgage loan.

• Compare all mortgage options: As you shop around, get quotes from at least three lenders and be sure to consider all your loan options — for example, USDA loans are ideal for those who live outside of an urban community. Remember that you can also negotiate with lenders to get better deals.

• Improve your credit score: To get the best interest rate on your mortgage, you need to have excellent credit. Take the time now to pay off your credit cards and don’t take out any new loans while you’re getting ready to apply for a home loan.

• Make a larger down payment: A larger down payment often gets you a lower interest rate. Try to save up for a 20% down payment to avoid having to pay private mortgage insurance (PMI). If you can’t put down 20%, aim for at least 5% — that's where you start seeing a decrease in interest rates.

• Consider mortgage points: Mortgage points are optional upfront payments that reduce your interest rate. One point typically costs 1% of the loan. When interest rates are high, buying mortgage points can save you money in the long term.

• Go for the ARM: You can usually get a better upfront mortgage rate by getting an adjustable-rate mortgage (ARM) rather than a fixed-rate mortgage. Keep in mind, though, that your monthly payments may increase after the fixed-rate period ends if you opt for an ARM.

What factors impact mortgage rates?

There are several factors that affect mortgage rates. The top factors are:

• Credit scores: If you have a higher credit score, you are more likely to receive a lower interest rate. If you have a lower credit score, the interest rates will be higher. Lenders use credit scores to determine the reliability of a borrower. The decision depends on your credit report, which shows your payment history, debts and loans. If you have a low credit score, it can prevent you from qualifying as a reliable borrower.

• Total home loan amount: The amount you would borrow as a mortgage loan Is the price of the home minus the closing costs and down payment in most cases. The closing costs may be included in the mortgage loan, however.

• Home location: Most of the lenders take the state or your home location into consideration before deciding on the interest rate. If you are interested in getting a rough idea of your potential rates, talk to multiple lenders in your area.

• Interest rate type: There are two basic types of mortgage rates: adjustable and fixed. Fixed interest rates do not change throughout the loan repayment period, while adjustable or floating rates change with the market.

• Loan type: Some broad categories of loan types are VA, USDA, conventional and FHA loans. Each type has different eligibility criteria and requirements. Mortgage lenders can help you determine which loans you’re eligible for and the best one for your situation.

• Rates heavily depend on the type of loan you and your lender choose. That’s why it is good to research about all types before making a commitment.

• Loan term: The loan term is the time in which you have to repay the loan. For instance, if you have less time to repay the loan, the interest rate would be low. But this also means higher monthly payments.

SHOPPING FOR YOUR MORTGAGE

How do you shop around for a mortgage?

Buying a house is a huge decision, so it’s important that you find the right mortgage lender to work with. When picking a mortgage provider, don’t be afraid to shop around. Getting multiple quotes from different companies and banks before you make a decision helps you find the best lender for your situation.

Reading reviews will help give you an idea of what to expect from working with different companies. Here are a few more tips to help you shop around, according to the Federal Trade Commission:

• Compare several lenders.

• Ask about all cost information, including rates, points, fees, down payment and private mortgage insurance premiums.

• Negotiate lender fees.

• Read the fine print.

LOAN TYPES

What are the different types of mortgage loans?

There are many types of mortgages for homebuyers. They can all be categorized first as conventional, government or nonconforming loans, and these loans can have fixed or adjustable interest rates. Refinance and renovation loans are considered second mortgages because they are loans taken out against a property that already has a mortgage.

• Government loans: When a government agency such as the Federal Housing Administration (FHA), Department of Veterans Affairs (VA) or the U.S. Department of Agriculture (USDA) insures a home loan that is issued by a private lender, that mortgage is considered a government or government-backed loan. These loans often have more lenient eligibility requirements than conventional loans.

• Conventional loans: Conventional loans are mortgages issued by private lenders that are not guaranteed by the federal government. Conventional mortgage loans are further classified as either conforming or nonconforming, depending on whether they conform to federal mortgage loan limits set by the Federal Housing Finance Agency (FHFA).

• Nonconforming loans: Nonconforming loans are mortgage loans that are above the federal conforming loan limits. These loans are also sometimes called portfolio loans since they have to stay on lenders' books and can't be sold to the government. Nonconforming loans are also called jumbo loans because they are available for higher amounts than conforming loans.

• Home renovation loans: Renovation loans are commonly taken out by both homeowners and homebuyers. If a homebuyer wants to purchase a house that needs some work, they can borrow money for the necessary renovations at the same time they are taking out money to buy their house. Combining the loan needed to purchase a home with the loan needed to renovate the home often gets you a better deal overall.

• Home refinance loans: Home refinance loans are a way for homeowners to pay off their current mortgage with a new loan. Often, home refinance loans are a way to lower monthly payments and reduce interest rates.

Compare mortgage types: Which mortgage is right for me?

The best type of mortgage for you is primarily determined by whether you meet the eligibility requirement of a conventional or government loan, the type of interest rate you prefer and the total amount you need to borrow.

Conventional loan vs. FHA and other government-backed loans

First, you need to determine if you qualify for a conventional loan or government-backed mortgage. A conventional loan is privately funded and offered by a bank or credit union. It is not federally guaranteed or insured. If a loan is guaranteed by a federal agency, then it is considered a government-backed loan. Government-backed mortgages are typically easier to qualify for than conventional mortgage loans. Both conventional and government-backed loans can be available with fixed or adjustable interest rate options, depending on lender programs.

• Government-backed mortgages have more relaxed lending guidelines and payment terms. They are ideal for low- and moderate-income borrowers with average financial profiles and credit scores. Some programs exist for specific groups or areas, like USDA loans for rural development or VA loans for veterans. Government-backed loans usually come with fixed interest rates, but not always.

• Conventional mortgage loans tend to have higher interest rates than government-backed loans, and their terms vary depending on the size and length of the loan, the borrower's financial profile and the financial market's current condition. Conventional loans are usually sought after by moderate- to high-income earners and can be used to finance investment properties and second homes.

Fixed-rate vs. adjustable-rate mortgages

Depending on what type of mortgage you get, you might have a choice between a fixed or adjustable interest rate. Your interest rate will vary based on the amount you pay your lender in addition to the amount of the loan, or principal. Figuring out if you want a fixed or adjustable rate often comes down to what interest rates are available to you at the time of purchase. Depending on your finances, a lower initial rate on an ARM might not be worth it if it increases in a few years and you're not financially prepared to cover it. Keep in mind that you can usually lower a fixed rate by shortening the length of time on the mortgage terms by five or more years.

• Fixed-rate mortgages are loans that have the same interest for the life of the loan. If you get a fixed-rate mortgage, you'll always pay the same rate until the loan is paid off in full — the interest rate is known at the time of issue, and the installment payments remain constant. Most borrowers opt for fixed-rate mortgages because they are more predictable and stable. Fixed-interest rates are best for borrowers who buy a home while interest rates are low.

• Adjustable-rate mortgages (ARM) are home loans with interest rates that change based on market conditions. An ARM will have one rate for a period of time and then reset based on the condition of the housing market. Most of the time, the adjustable-interest rate will fluctuate monthly, quarterly, annually or once every three years. For example, a 5/1 ARM will have a fixed rate for the first five years of the loan and then adjust once per year after that; a 7/1 ARM is fixed the first seven years and followed by yearly adjustments. Adjustable interest rate mortgages are generally considered to be more risky for the borrower because of their volatility.

Conforming vs. nonconforming loans

Whether you need a conforming or nonconforming loan will likely be determined by how large of a loan you need. A conforming loan is a mortgage for any amount within the federal loan limit. This doesn't mean it's impossible to get a loan above the conforming limit, but the loan will be nonconforming and therefore can't be securitized by Fannie Mae or Freddie Mac.

• Conforming loans are mortgages for amounts that are within the conforming limit set by the Federal Housing Finance Agency. As of 2020, the FHFA sets conforming loan limits at $510,400 in most parts of the country and $765,600 in some high-demand housing markets. All conforming loans fall within these maximum loan limits. With a conforming loan, you'll typically be able to make a lower down payment or pay a lower interest rate than with a nonconforming loan that is not backed by a government-sponsored enterprise (GSE). Most first-time homebuyers get conforming loans.

• Nonconforming loans are mortgages that exceed federal conforming limits and cannot be secured by a GSE such as Fannie Mae or Freddie Mac. If you need to mortgage a house in an area with much higher than average median housing prices, your only option might be to take out a loan for an amount greater than federal conforming limits. Nonconforming loans are best for high-income homebuyers who want to borrow above the limits of conforming loans and are willing to pay higher interest rates or make a larger down payment.

How does refinancing work?

Mortgage refinancing companies replace your existing mortgage with a new loan. The two most common types of home refinance loans are rate-and-term refinancing and cash-out refinancing.

Through rate-and-term refinancing, you can change your term, get a new rate and pick a new type of loan and lender. Rate-and-term refinancing doesn’t affect your principal balance, and it’s possible to save on interest in the long term if rates have gone down since you first financed your mortgage.

With a cash-out refinance, you access your home equity in exchange for a higher principal. For example, imagine you owe $50,000 on your mortgage and want a $10,000 loan. Through a cash-out refinance or home equity loan, you could accept a $60,000 loan and receive $10,000 in cash after closing.

Many homeowners refinance their mortgage to lower their monthly payments, get a better rate, convert home equity into cash or pay off their loan faster. Some mortgage refinance lenders also specialize in debt consolidation strategies. For more, read about how to refinance a mortgage.

CLOSING COSTS

What are closing costs?

Closing costs are fees paid at the end of the homebuying process. They’re due at closing, which is the final meeting between buyers, sellers and real estate professionals, when the title is officially signed over to the buyer, making the home purchase official. Closing costs include insurance, appraisal fees, taxes and other fees associated with the purchase of a home. You’ll get an estimate of your closing costs in your Loan Estimate, and the final closing costs are included in your Closing Disclosure.

How much are closing costs on a house?

Closing costs typically range from 2% to 5% of the total home loan amount. In 2019, the average closing cost paid by a homebuyer was $5,749 (including taxes). For a home that costs $285,000 with 20% down, typical closing costs would fall around $7,000. Where you live can also greatly affect your closing costs — these costs tend to be higher on the coasts, particularly in East Coast states including New York, Delaware and the District of Columbia.