What is a mortgage interest rate?

Mortgage 101
Find out what exactly a mortgage interest rate is, how they're calculated, and what you should know before deciding on one.
Published on
July 25, 2023
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When you see the listing price of a home, this isn't actually the price that you'll be paying over the course of the loan unless you can purchase the entirety of the home with your own cash. Anything that remains after your down payment will likely need to be provided to you with a standard mortgage loan. Any lender that provides mortgages to borrowers is taking on a certain amount of risk for doing so. Lenders are able to mitigate this risk by charging an interest rate, which will be attached to your monthly mortgage payment. This article offers a descriptive look at mortgage interest rates and how they are determined.

What Is a Mortgage Interest Rate?

The mortgage interest rate that will be assigned to your loan is the amount of money that you must pay each month to effectively finance your property. This rate is placed on top of the amount that you owe from the loan itself, which is referred to as the principal of the loan. Both the principal and interest that you pay will be included as part of your monthly mortgage payments. Think of interest as compensation you owe the lender for using their money to buy a home.

When you're searching for the best interest rate, keep in mind that interest rates can differ when it comes to adjustable-rate and fixed-rate mortgages. When you have a fixed-rate mortgage, your interest rate will remain the same over the entire loan term, which allows for consistent and predictable monthly mortgage payments. In many cases, fixed-rate loans have slightly higher interest rates than adjustable-rate loans.

As for adjustable-rate loans, your interest rate may begin to fluctuate after a certain amount of time has passed. When you apply for this type of loan, the initial interest rate that you receive will remain fixed for a period of 5-10 years. Once the initial period is over, your interest rate will change after every 12 months.

While you will likely receive a relatively low interest rate to start out, it's important to understand that interest rates could increase every time these rates are adjusted, which means that you would potentially be spending far more money than you otherwise would have. On the other hand, your interest rate could drop, which means that there is an element of risk/reward that you should take into account before deciding which type of mortgage is right for you.

Difference Between an Interest Rate and APR

Before you apply for a loan, you should understand the difference between an interest rate and an annual percentage rate, both of which are part of the home-buying process. The interest rate that your lender charges is the amount of money that you must pay each year to borrow the lender's money. This rate is displayed as a specific percentage, which could be anything from 1.5% to 5%. While this rate is essential for your mortgage loan, it doesn't include any other fees that you're expected to pay.

The annual percentage rate is more comprehensive than the interest rate and is designed to reflect the numerous costs that are incurred when borrowing money. The primary costs that are the annual percentage rate takes into account include the mortgage broker fees, any discount points you purchase, and the interest rate. As such, your APR will be higher than your base interest rate.

If you've already received a loan estimate from your lender, you will be able to view the estimated interest rate and APR. The interest rate should be found under the "Loan Terms" subheading, which is located on page one. As for the APR, it should be listed under the "Comparisons" section on page three.

Before you start to perform comparisons to the numerous loan options available to you, it's important that you understand how APR and interest rates affect the loan. When you're looking at the APR of an adjustable-rate loan, the rate that's listed won't accurately reflect how high your interest rate can get.

You should also avoid performing comparisons between fixed and adjustable rate mortgages. As mentioned previously, the interest rate for an adjustable-rate mortgage usually starts out lower when compared to the rate for a fixed-rate mortgage. However, this doesn't mean that an adjustable-rate mortgage is right for you and your specific situation. With these considerations in mind, you shouldn't find it too difficult to compare the different quotes you receive while searching for the best interest rate.

How an Interest Rate is Determined

There are many factors that dictate what interest rate you'll receive from a lender. While some of these are personal factors, others are economic factors that can tell you if now is the right time to buy or if you should wait. Knowing what these factors are can help you anticipate when interest rates will be at their most favorable. The primary factors for you to keep in mind include:

  • The current economy and real estate market
  • Details of your loan
  • The type of loan you're applying for
  • The total amount of the loan
  • Your down payment
  • The location of the home
  • Your personal details
  • Your credit score and credit history
  • Any existing debt you have
  • Any existing assets you have
  • Employment and income history

While you can't do anything to change the economic factors that determine what your interest rate will, there are things you can do to improve your personal details. When it comes to the broader market, the inflation rates, strength of the economy, consumer spending, and employment numbers can all dictate what interest rates will look like from most lenders.

The personal factors are much more important if you want to take steps to improve your chances of obtaining a low interest rate when you apply for a mortgage. For one, your financial situation will display to lenders how risky it is to provide you with a loan. If you have an ample amount of savings as well as consistent income, you may be able to receive a low interest rate.

Another notable factor that substantially influences the interest rates you receive is your credit score. In fact, most types of mortgages have a minimum score that you must have if you want to be approved for a mortgage. Having a higher credit score should help you obtain a lower interest rate. If you want to obtain the lowest possible interest rate from your lender, make sure that you:

  • Have a low loan-to-value ratio
  • Have a low debt-to-income ratio
  • Make a down payment of 20% or higher
  • Have a credit score of at least 760
Steps You Can Take to Change Your Interest Rate

If you want to make sure that the interest rate for your mortgage is as low as possible, there are several steps you can take to effectively change your interest rate. As mentioned previously, there are many personal factors that help determine what type of credit score you'll receive. By improving these personal factors, you may qualify for a lower interest rate. It's also highly recommended that you compare different lenders to identify the lowest rate available.

Increase Your Down-Payment Amount

Among the most effective ways to reduce your interest rate is to increase your down payment. The down payment that you're expected to pay is the amount of upfront money you provide. When you make a down payment of 20%, this means that you have paid 20% of the total home price. As such, the lender only needs to cover 80% of the costs when providing you with a loan.

If you lessen the amount of money that the lender needs to borrow, this will essentially reduce the lender's risk of providing you with a loan. Lower risk equates to a lower interest rate. You'll likely notice that most lenders have a minimum down-payment amount that they will accept. While you can obtain a mortgage by paying the minimum down payment, your interest rate will likely be high, which you should take into account.

Buy Discount Points

Another great method for reducing your interest rate is by purchasing discount points, which are designed specifically for lowering interest rates. Purchasing a single point allows you to reduce your interest rate by around 0.25%. In most cases, lenders allow borrowers to purchase as many as four discount points at the beginning of the process. Keep in mind that each discount point usually costs 1% of the loan amount. If you're purchasing a $300,000 home, one discount point will cost $3,000.

Improve Your Credit Score

Finally, you should look into improving your credit score if you want your interest rate to be lower. A high credit score indicates to the lender that you have a strong history of making payment on time. If your credit score is too low, lenders may believe that you're at risk of defaulting on the loan. While many prospective homeowners believe that it's too difficult to improve their credit scores, the truth is that there are many small things you can do to quickly increase your score. If you have any outstanding debts or missed payments, start paying these debts off now.

When your debts decrease, your score will go up. If you use a credit card, try to keep your credit card utilization to less than 30% each month. If you have a credit limit of $12,000 per month, you should spend less than $3,600 per month on the card. It's also important to pay at least the minimum balance each month to avoid a decrease in your credit score. By making these small changes, you should soon start to notice your credit score increasing, which will help you receive a lower interest rate.

Interest rates determine how much you end up paying over the course of your loan. Even if the current quotes you've received indicate that your interest rate will be relatively high, the steps mentioned above can help you improve your financial situation and obtain an interest rate that's more reasonable.

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