Not sure how mortgage rates work? Today we’ll explain them for you.
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Learn how mortgage rates affect your home purchase
What Are Mortgage Rates?
A mortgage rate is used to determine how much it will cost for you to borrow money to pay for your home each year. It is calculated as a percentage.
For example, if you have a mortgage rate of 5%, then you will pay 5% of your total mortgage balance back to your lender each year.
Your mortgage rate can have big impact on the amount of money that you actually pay over the life of your mortgage. A higher mortgage rate means you pay more money for your home.
Here's a great overall summary of the basics of mortgage rates
The Amount of Interest You Pay Goes Down as Your Mortgage Balance Goes Down
Interest is a “lender’s reward for taking a risk” to loan your money. It is the payment that they receive for letting you use their money to buy your home. Your lender will receive more money at the start of your mortgage than as it is paid down.
At the start of your mortgage payments, you will be paying more for interest and less on the principal or balance of your mortgage. This is because your mortgage rate determines the amount of interest you pay on the balance of your mortgage.
At the beginning of your mortgage payments, your balance is at its highest point. However, as you make your monthly payments, your balance gradually decreases so that the percentage that you pay in interest decreases as well.
You pay more interest at the beginning of your mortgage
How Your Mortgage Rate Determines the Interest Portion of Your Mortgage Payment
If you take out a mortgage for $100,000 and amortize it over 30 years (meaning you will be paying it back over a 30 year period), the balance or principle you need to pay back is $100,000. If your interest rate is 6%, then your monthly payment will be about $599.55.
Your first mortgage payment will be split up as follows: $500 in interest and $99.55 in principal. However, on your next payment you will only be paying $499.50 in interest because your first payment brought down your balance by $99.55 so you were paying 6% of a slightly smaller number.
This decrease in interest payment and increase in principal payment will continue until at the end of your 30 year amortization period, most of your monthly payment will be going to pay off your principal.
So, by the beginning of your 30th year, you will be paying $8.91 in interest and $590.64 in principal. This is assuming that you have a constant interest rate of 6%.
Different rates will change the amounts that you pay, but the idea that you pay more at the start in interest and less at the end of your mortgage will still apply.
Here’s a great mortgage calculator that will give you the breakdown of your principal and interest payments in different scenarios.
By the end of your amortization period, most of your monthly payment will go towards principal
Interest Rates Can Change Each Term of Your Mortgage
You will not have the same mortgage rate throughout the entire time of your payments. The term is the length of time that you agree to a certain interest rate and payment amount.
The term can range anywhere from 6 months to 25 years. Interest rates will vary depending on the term that you choose. A shorter term will usually have a lower interest rate. This is because it is difficult to predict what the financial situation will be the further you go in the future so the risk for the lender is greater.
If they give you a really low rate for 25 years and interest rates in general go up, they could be in trouble. So they set a higher rate to cover this risk.
On the other hand, you might feel more comfortable locking in for a longer term and taking a higher interest rate in order to have peace of mind knowing what your interest payments will be.
If you choose a shorter term, you will be paying less interest. However, you may be running the risk of interest rates going up when you term is over.
You really need to decide on how much risk you are comfortable with and how much interest you want to be paying when buying your home.
A shorter term will usually give you lower mortgage rates
Variable vs Fixed Mortgage Rates
Variable Mortgage Rates: A variable mortgage rate will change as the interest rates go up and down over the term of your mortgage. This means that your payments will also vary during this time. Because they are riskier, variable rates are lower than fixed rates.
Fixed Mortgage Rates: With a fixed mortgage rate, your interest rate will stay the same throughout the term that you choose and your payments will also be the same.
In the past, people tend to pay less interest by choosing a variable rate, however, that isn’t a guarantee. You have to decide which option you are more comfortable with.
Learn more about the difference between variable and fixed mortgage rates
What Factors Affect Mortgage Rates?
Mortgage rates are not static. They go up and down. There are many factors that affect mortgage rates. Usually, mortgage rates will go down when:
- The stock market goes down
- There are fluctuations and uncertainties in foreign markets
- Inflation slows down
- Unemployment goes up and the availability of jobs goes down
On the other hand, mortgage rates will go up when:
- The stock market is doing well
- There is stability and strength in foreign markets
- Inflation goes up
- Unemployment goes down and there are more new jobs
Mortgage rates are affected by stock markets
What Affects the Mortgage Rates that You Are Offered
Not everyone receives the same mortgage rate. The general rates fluctuate according to the factors we outlined above, but lenders will also take into consideration your own financial situation when to determine the actual rate that they offer you.
When determining your mortgage rate, they will look at things like:
- Your credit score
- You repayment history: have you had any bankruptcies, collections, etc. in your past
- Your income and employment history
- Your debt load and your cash reserves and assets
- How much of a down payment you have
- The location of the property you are mortgaging
- The type of mortgage you want and the term
On the whole, if you pose a higher risk to your lender, then your rate will be higher. If the amount that you are borrowing is a higher percentage of the value of the property, then your rate will be higher.
Learn more about credit scores
It Pays to Shop Around for the Best Mortgage Rate
Mortgage rates can vary quite a bit from lender to lender. That is why it is a good idea to shop around to get the best rate possible. You can apply for a mortgage with several different lenders or you can use a mortgage broker who will search many different lending avenues for you to try and get you the best rate.
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