The interest rate on your mortgage has a major effect on how much you pay for your loan. Getting a lower interest rate can save you a lot of money — both in the short term and in the long run.
The interest rate your lender offers will depend on both your financial history and current market conditions. Here’s a look at the importance of interest rates, and how they affect what you pay for your mortgage.
How Mortgage Interest Rates Work
Your interest rate is used to calculate how much you need to pay beyond the principal — aka the total amount you are borrowing — to pay off your loan. It’s expressed as a percentage rate.
The monthly mortgage payment is a major regular expense for most homeowners. The amount you have to pay your lender each month consists of your loan costs, as well as any contributions to an escrow or impound account used to pay other charges. A typical payment amount will include:
- Homeowners insurance.
- Property taxes.
- Mortgage insurance, if necessary.
- Homeowners association fees, if necessary.
So, how much does your interest rate affect your monthly mortgage payment? A higher interest rate means you’re paying more interest each month. A lower interest rate means you’ll pay less.
Total interest paid
In addition to raising your monthly payment, a higher interest rate means you’re paying more in total interest for your loan. Over time, even a small difference in the interest rate or the monthly mortgage payment can make a big difference in the total amount you’ll pay.
Fixed-rate mortgages vs. adjustable-rate mortgages
With a fixed-rate mortgage, your interest rate is set when you take out the loan and won’t change. That means the amount you owe for principal and interest each month is predictable. With an adjustable-rate mortgage, your interest rate is subject to change — so your monthly payment will fluctuate from time to time.
ARMs often start with a lower interest rate than fixed-rate loans, and stay at that rate for an introductory period lasting a few months to a few years. Once this period is over, the interest rate on an ARM will change according to a schedule.
When your rate increases, your monthly payment also increases. When it declines, your payment also goes down. The direction in which your interest rate adjusts depends largely on broad economic and market conditions.
A Small Change in Your Mortgage Rate Makes a Big Difference
If the difference between two interest rates is 1 percentage point, you might not think it will make much of a difference. But according to the Consumer Financial Protection Bureau, saving just a fraction of a percentage point on your interest rate can save you up to thousands of dollars over your loan term.
Consider the following example illustrating the difference in costs if you bought a $400,000 home with a 20% down payment and took out a 30-year fixed-rate mortgage for the remaining $320,000 at different interest rates:
Example Costs for a 30-Year Fixed-Rate Loan for $320,000
|Mortgage interest rate
|Total interest paid
How To Lower Your Interest Rate
The interest rate you’re offered will depend on a number of different factors, including your credit history, down payment amount, location, loan type, and loan term. The following are some steps you can take to help score a lower interest rate.
Improve your credit
As a general rule, a higher credit score gets you a lower interest rate, and a lower score gets you a higher rate. One way to receive a better interest rate is to improve your credit before you apply for a loan. You can boost your credit score by paying your bills on time and reducing the amount of debt you owe. It’s also wise to review your credit report before you contact a lender, so that you can check it for accuracy and dispute any errors with the credit reporting bureau.
If you’re unable to get a low interest rate when you first take out your mortgage, that doesn’t mean you’re stuck with that rate for the entire loan. If interest rates drop or you’ve managed to improve your credit score, it might be worth refinancing to lock in a lower rate. It also may be worth refinancing if you have an ARM and want to switch to a fixed-rate loan.
Purchase mortgage points
Another way to get a lower interest rate is to buy mortgage points when you take out your loan. Points let you pay some interest upfront in exchange for a lower interest rate. While mortgage points increase your closing costs, the lower interest rate reduces your monthly payment and the amount you pay in overall interest.
Each mortgage point costs 1% of your mortgage loan. So, 1 point on a $400,000 loan would equal $4,000, and 2 points would be $8,000.
Your lender is required to reduce your interest rate if you pay points, but the exact amount that it is reduced by will vary by lender.