Email FacebookTwitterMenu burgerClose thin

How Do Mortgage Rates Work?


When you take out a mortgage to buy a home, you will have to pay back both the balance that you borrowed (referred to as the principal) and the interest that pays for the cost of the loan. How much you will pay in interest depends on the size and type of mortgage, your down payment and your credit score, as well as other factors beyond your control like changes in monetary policy, economic growth and inflation. Let’s break down how mortgage rates work.

If you’re looking to buy a home, a financial advisor can help you put a financial plan together for your needs and goals.

What Is a Mortgage Rate?

A mortgage rate represents the interest rate that a lender charges for a home loan. This rate determines the borrower’s monthly payments as well as the aggregate cost of the home over the duration of the loan. Understanding your mortgage rate will help you strategize your home buying decisions, select the right mortgage plan, or decide the most opportune moment to refinance an existing mortgage.

Generally, when you buy a mortgage, your lender will finance at least 80% of the value of your home, which you agree to pay back with interest during a specific time – mortgage terms can be as short as 10 years, and last 15, 30, and now 40 years.

As an example, let’s take a look at a 30-year mortgage for $200,000 using SmartAsset’s mortgage calculator. If the mortgage rate is 3% with a 20% down payment, the total interest paid over the life of the loan would be $82,714. But if that rate increases to 4%, you would pay $114,796 in interest. So with just a 1% increase, your mortgage will cost you just over $30,000.

Fixed Mortgage Rates vs. Variable Mortgage Rate

Husband and wife discuss their mortgage rate

There are two main types of mortgage rates: Fixed and variable. Let’s compare the differences:

Fixed mortgage rates. These are characterized by steady rates that remain unchanged throughout the term of the loan. As a result, your monthly payments will also remain the same. Terms can vary from 10 to 40 years, with shorter time frames typically requiring bigger monthly payments at lower interest rates.

Variable mortgage rates. These, conversely, flux with changing market conditions. And, since your interest rate isn’t locked, your monthly payment will also change during the lifetime of the loan. Many of these loans limit how much your interest can fluctuate. And, as your rate goes up or down, your mortgage lender will recalculate your monthly payment.

How Mortgage Rates Relate to the Economy

The Federal Reserve’s monetary policies can impact your mortgage rates. For example, when the economy dips, the government agency may choose to lower interest rates to stimulate growth. And consequently, this can lead to lower mortgage rates and potential savings for homebuyers and homeowners. 

But, lowering rates can also give rise to inflation, which could also undermine the overall health of the economy. This could lead the Federal Reserve to raise interest rates to slow down the economy. And higher interest rates will also make your mortgage rate higher.

How Mortgage Rates Are Determined

Your mortgage rate can vary, depending on these four common factors:

1. Credit score: Your credit score will determine whether you can qualify for a mortgage. And with a higher score, you may be able to get better terms and a lower interest rate.

2. Down payment: In general, putting more money down upfront, will get you a better mortgage rate. If you cannot afford to put 20% down, your lender may require you to get mortgage insurance, which could increase your rate or get added on to your overall monthly payments.

3. Loan term: Mortgages can range from 10 to 40 years, with shorter-term loans typically charging lower interest rates but higher monthly payments.

4. Loan type: Rates can differ significantly depending on the type of home loan that you choose. Therefore you should speak with more than one lender to fully understand which options you can apply for.

Bottom Line

Husband and wife meet with a financial advisor

When shopping for a mortgage, make sure you take into account how much interest you will pay. The difference of 1% can cost you thousands of dollars in the life of your loan. Also, take a look at the type of mortgage rate and loan, as well as the terms and other factors when developing your home buying strategy.

Tips for Home buyers

  • A financial advisor can help you reach your home buying goals. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • If you want to know how much of a mortgage you can afford, SmartAsset’s affordability calculator can give you an estimate based on your income, savings and monthly debts.

Photo credit: ©, ©, ©