How Interest Rates Work on a Mortgage?

By Kelly B. — Published May 14, 2018

How Interest Rates Work on a Mortgage?

Buying a good home in today's market means one must be ready to pay a huge sum of money upfront. Although this sounds simple enough, most people don't have enough cash to pay the sum upfront. That's when people take mortgages on their homes.

A mortgage is a debt provided by a lending agency to a person in order to buy a home or property. The property is kept as collateral and the individual buying the home is charged an interest during the repayment of the debt.

Reports have shown that nearly 49% of homes that are priced north of a million dollars are bought on a mortgage.

When taking a mortgage on a home, one of the most important considerations is the interest rate on the mortgage. It is crucial to understand how interest rates work on mortgages in order to help you choose what works best for you.

Typically, about 80 percent of the cost of a home is financed with the help of a mortgage.

In most cases, mortgages are repaid month by month.

The structure of a mortgage payment plan

Your monthly payments are divided into two. A portion of it goes towards paying the principal amount or the mortgage and the rest goes into paying the interest on the mortgage.

The mortgage and interest are paid back according to a payment schedule called an amortization schedule determined by the lender.

An amortization schedule is a periodic payment schedule in which the balance of a debt is reduced with each periodic payment. The period of your payment schedule is a factor in determining your monthly payments.

If you are in no hurry to pay off your mortgage at the earliest possible moment, then stretching out your payment period will lower your monthly payments.

During the initial period of your repayment schedule, you will find that most of the payments go towards the interest and very less goes into paying off the principal amount. The scenario changes as you enter the final stages of your loan repayment. Very little of your payments go towards the interest while the majority goes towards paying off the principal amount.

Mortgage payments also include additional costs like insurance and taxes other than the principal and the interest.

When it comes to taking a mortgage, one must understand the different types of mortgages available:

Fixed-rate mortgages

In such mortgages, the lending agency charges an interest rate that remains fixed throughout the payment period. Such loans can be paid off within thirty years if the creditors wish. The longer the payment period, the lower is the monthly payment.

Short-term loans, however, have the advantage of being paid off rather quickly in addition to lower interest rates. The monthly payments are higher in case of a short-term loan.

Adjustable-rate mortgage

Also known as ARM, in this form of mortgage, the interest rates depend on certain factors and monthly payments can fluctuate. For instance, if interest rates happen to rise during a specific month, then your monthly payments are likely to rise as well. Once the rates drop, appropriate adjustments are made for the next monthly payment.

Even though the interest rates are bound to change, lenders cannot charge interest beyond a certain limit.

If you plan to take an ARM, then keep in mind the factors that are likely to affect the interest rates. Also, try to understand how the interest rate may vary over the years.

Interest-only loans

These loans are reserved for people who wish to buy a home, but do not have a regular income. It charges very low rates of interest and is ideal for people who are buying a home for the first time.

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