how does mortgage interest work

How Do Interest Rates Affect Your Mortgage & Monthly Payment

Suddenly, there’s a little more housing stock available in lower brackets. Unfortunately, interest rates are going up. (And up. And up.)

How does that impact your monthly payment? Is it still worth it to purchase a house?

How does mortgage interest work?

I have good news and bad news for you.

The good news: Long-term, you could be in a better situation.

The bad news: Short-term, it’s a little dire.

Ultimately, if you ever want to be a homeowner, you’ll benefit from getting into the market now, regardless of the current mortgage rates.

I’ll explain why.

First: How Does Mortgage Interest Work?

A mortgage is a loan that you get to buy property. The interest is the price you pay for borrowing money.

The amount of interest you pay depends on the following:

  1. The size of your loan (the “principal”),
  2. The term of your loan (how long you have to pay it back),
  3. The interest rate.

So, the interest rate is the price you pay for borrowing money, expressed as a percentage of the total loan.

Mortgage rates can be either fixed or variable. A fixed interest rate means that your payments will stay the same for the life of your loan. A variable interest rate means your interest will go up after a set period, usually three to five years.

Variable interest rates are almost always a trap. If you’re savvy, go for it. But you probably shouldn’t if you don’t know what a variable interest rate is or why it’s so dangerous. Your mortgage rate could increase dramatically just because the Fed increases rates, and suddenly your house won’t be affordable anymore.

Mortgage interest is also front-loaded. What does that mean? You pay more in interest than the principal at the beginning of the loan, and you pay more in principal than interest at the end of the loan. So, you don’t build much equity within the first five years of ownership.

But all that is pretty boring. You probably want to know how mortgage rates will impact your mortgage and your monthly payments.

how does mortgage interest work

How Mortgage Rates Impact Your Mortgage

Interest rates have a tremendous impact on your mortgage. Your mortgage rate has a direct impact on affordability.

Suppose you bought a $400,000 house a year ago when interest rates were at all-time lows-3%. Over 30 years, you’d pay $207,000 in interest (give or take a few dollars).

Now, consider buying that same $400,000 house today. Now you’re paying interest rates at 6%. Yes, 6%. Over the next 30 years, you’ll pay $463,000 in interest. So, you’re looking at over double the amount for a home loan on the same property.

But that’s not the core problem. The core problem is affordability. And that relates to your monthly payments rather than the mortgage rate you pay over time.

Monthly Payments and Mortgage Interest

Banks determine how much you can afford based on your monthly payment. When they calculate this, they calculate everything: principal, interest, taxes, property insurance, etc.

So, let’s say they decide that you can spend exactly $2,000 on housing.

Going back to our example. A $400,000 house at 3% will be roughly $1,686 a month. That’s well within your budget. The bank is happy; you’re happy.

Now, a $400,000 house at 6% is… yikes. Nearly $2,400 a month. It’s the same house. But at a significantly higher cost.

Now you no longer even qualify for a $400,000 house.

In fact, at an interest rate of 6%, you only qualify for a $350,000 house. Suddenly, $50,000 has been slashed off your budget. The house hasn’t changed, and your income hasn’t changed. But your monthly mortgage payment certainly has.

The only thing that’s changed is your mortgage interest rate.

how does mortgage interest work

The Relationship Between Housing Prices and Mortgage Interest

But I told you there was both good and bad news. And there is.

So, you’ve seen housing prices start to slow. They’re not exactly decreasing, but “starter homes” stay on the market a little longer. A $400,000 house isn’t going for $350,000, but you can find a $350,000 house now. That’s because the amount borrowers can qualify for has lowered, putting many people out of the market.

Since we discussed how mortgage interest impacts your monthly payments, you know you’re paying the same amount (effectively) for that $350,000 house. Your monthly payments are the same for a $350,000 house at 6% as they would for a $400,000 house at 3% (more or less).

But here’s the good news.

The good news is that most people don’t carry a mortgage for 30%. If you purchase a $350,000 house at 6% today, you may be able to refinance it for less within five years. It may never be down to the 2-3% rates we were getting, but even at 4%, it will be way more affordable.

More to the point, if you buy now, you’ll build equity. You own that equity free and clear. Whether you are paying 6% or 10% interest, if your house increases in value by $50,000, you’ve increased your net worth by $50,000. And that’s money that you can put toward your next property.

Further, even if you’re paying significantly more interest, you will still come out ahead. Look at this chart based on estimated appreciation, which is historically 5.4% according to NAR.

202120222022
Interest Rate3%6%6%
Loan Amount$400,000$400,000$350,000
Monthly Payment$1,686$2,398$2,098
Lifetime Cost$607,110$863,353$755,434
Est. Value after 30 Years$1,937,000$1,937,000$1,695,000

We’ve been assuming some great 0% down loans like the VA loan for this exercise. But regardless, the point is—you’re ultimately building huge amounts of equity regardless of the interest rate.

Paying Down Points for Lower Interest Rates

I should mention that buy points are one way to lower your interest rate and monthly payments.

You can do this when you purchase the property or refinance it. Essentially, you’re paying extra now in exchange for a lower interest rate later. So, if you’re looking at a 6% interest rate, you may be able to buy down one point and lower it to 5.75%.

One point equals 1% of the loan amount, so on a $350,000 loan, one point would be $3,500.

You can usually buy down as many points as you want/can afford. But here’s the thing. Buying down points is never a good idea if you think you will refinance in the future. It only makes sense if you hold that property for ten years or more. You’re taking on an upfront cost to reduce your interest over time-the longer you hold the mortgage, the more useful that becomes.

The average person will sell their house within six to ten years. Consider whether you are going to be within that average.

does earnest money go towards down payment

Other Ways to Lower Your Rates

There’s another way you can lower your rates. You can go for an adjustable-rate mortgage rather than a fixed-rate mortgage. But as mentioned before, that’s not a great idea. It’s better to improve your credit score than try for an adjustable-rate mortgage because a variable rate can hit you at the worst possible time.

You can also shop around for a different lender. Maybe Rocket Mortgage will give you a better deal if you work with one of their realtors. A local lender can give you a better rate if you have a great credit score. You should always look at a few lenders when getting a mortgage loan; each mortgage lender has its rates, too.

The Future of Mortgage Interest Rates

The housing market is slowing down. It’s everywhere in the news. But that doesn’t mean housing prices are increasing or that mortgage interest rates are decreasing. It means that the acceleration is decreasing in speed. Still, it’s good news for buyers.

But mortgage interest rates are likely to keep going up.

Expert analysts have guessed that mortgage interest rates will be around 6% by the end of the year. That’s the base interest rate. You can get that by having great credit. But you will need great credit.

Right now (mid-2022), mortgage interest rates are already at around 5.5%.

Believe it or not, these rates are still historically low.

Can I Use My 401k to Buy a House?

A Brief History of Mortgage Interest Rates

For most of history, people didn’t borrow money to buy homes. They either paid cash or worked out a trade.

It wasn’t until the 1930s that the modern mortgage system was created. The Great Depression hit, and people stopped buying homes-the housing market crashed. So, the government stepped in and created Fannie Mae. Fannie Mae’s job was to buy mortgages and help keep the housing market afloat.

This system worked well. So well, when the time came, Fannie Mae could go private again.

Mortgage interest rates stayed low for decades. In the 1950s, they hovered around 4%. In the 1960s, they averaged just over 5%.

It wasn’t until the 1970s that rates began to rise.

The ’70s were a time of high inflation. The economy was struggling, and mortgage interest rates reflected that. They averaged around 8% in the early ’70s and rose to nearly 11% by the decade’s end.

how does mortgage interest work

Source: St. Louis Fed

This is all to say that by the 80s, interest rates approached a staggering 20%. That’s right. Interest rates were around the level of a subprime credit card. Houses were a lot less expensive. But they were also much smaller.

The American demand for larger luxury properties has driven prices to go higher. We get more bang for our buck but still need to spend more.

All that is to say…

Should You Buy Despite the Mortgage Interest Rates?

The answer is: it depends.

It depends on your financial situation, goals, and your area’s market conditions.

If you’re considering buying a house, now is a good time to start researching. Get pre-approved for a mortgage so you know what interest rates you’re looking at. Work with an agent to find the right houses.

If you can find a house that fits your monthly budget comfortably at the interest rates now… you need to buy it. The reality is that interest rates are still historically low, and housing prices only go up. Even when the market crashes… it eventually goes up.

You’ll get priced out if you don’t get into the market right now. I can’t emphasize that enough. You need to start to build home equity if you can.

However, don’t do it if you cannot buy a house comfortably within your budget. That’s another reality: Some people have been priced out of the market. That doesn’t mean that your dream of homeownership is dead. It means that you need to change what you want.

Buy a condo if you can’t afford a starter home. Use that condo to build equity. Buy in a cheaper area. Get a remote job. Upskill and get more income. But don’t purchase a house that you can’t afford.

earnest money vs down payment

FAQs

How is interest calculated on a mortgage?

Interest is calculated on a mortgage by taking the principal loan amount and multiplying it by the interest rate, expressed as a decimal. The resulting number is added to the principal loan amount and becomes your new balance. This new balance is then used to calculate the next month’s interest payment.

How much interest will I pay on my mortgage over 30 years?

The interest you’ll pay on your mortgage over 30 years depends on the interest rate, principal loan amount, and monthly payment. To calculate the total interest you’ll pay, multiply your monthly payment by 12 (months in a year), then multiply that number by 30 (years in a term). There are also calculators online that can help.

How long do you pay interest on a mortgage?

Mortgage interest is paid monthly, along with your principal payment. You’ll continue making these payments until your mortgage is paid in full.

Is mortgage interest compounded monthly or yearly?

Mortgage interest is usually compounded monthly. This means the interest you pay each month is added to your balance, and the next month’s interest payment is calculated on this new balance.

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