How Do Mortgage Rates Work? A Complete Guide

In the US, around 44% of Americans have a mortgage. Buying a house is a huge financial deal, so it’s very normal to borrow money to secure that dream home.

Maybe you’re at a point in your life where you have a decent amount of money saved up and you’re ready to move onto the next stage of adulthood. Becoming a homeowner can be exciting yet daunting, so naturally, you’ve probably got a bunch of questions.

If you’re wondering, “how do mortgage rates work,” then you’re in luck. This article will lay out everything you need to know so you don’t go into buying a house blind!

What’s a Mortgage?

First things first: what’s a mortgage exactly? This is a large-sum loan you can use to finance the purchase of a home. Typically, lenders will give you 80% of the property price.

While you can get a mortgage from your bank (or other ones), you can also get them from credit unions, mortgage brokers (such as this broker), and mortgage marketplaces.

How Do Mortgage Rates Work?

When you apply for a mortgage, the lender will tell you how much interest you’ll have to pay on your loan. This means that not only will you have to pay back the amount borrowed, but a little extra. This is how they’ll make money off of lending it to you.

Historically, mortgage interest rates range from 1-4%, depending on the term length you choose. To get the lowest rate possible, you’ll want to select a longer term length, such as 30 years (this is what most homeowners go for).

Shorter term lengths have higher rates attached to them, as well as bigger monthly payments. However, you’ll be paying less in interest when you look at the big picture, especially when compared to 30-year mortgage rates.

Whatever you choose, in the majority of cases, whenever you make your monthly payment, a small amount goes towards paying the interest and the rest goes towards the principal (the base loan amount). There are some exceptions, but we’ll discuss that later.

Types of Mortgage Rates

There are 2 main types of mortgages: fixed-rate and adjustable-rate. There are also interest-only and jumbo mortgage loans, which we’ll also discuss. Read on to find out more about each type.

Fixed-Rate Mortgage

As the name suggests, with a fixed-rate mortgage, the rate stays the same for the entire lifetime of the loan. So if you signed a mortgage with a 2% interest rate, that’s how much you’ll pay for the next 10 to 30 years. Because of this, you can expect your monthly payments to be the same too.

If you have good income, a fixed-rate mortgage can be worth it. While most people opt for a 30-year loan, some go for 10, 15, or 20. The monthly payments are much bigger, but they’ll be paid off quicker, which means you’ll spend less on interest costs.

For all the above reasons, a fixed-rate mortgage is good for those who plan on staying in their homes long term.

Adjustable-Rate Mortgage

Adjustable-rate mortgages are also known as variable-rate mortgages or hybrid loans. So instead of paying something like 2% all throughout the lifetime of your mortgage loan, you might pay 1% at some points and 3% at others. As you can see, this can possibly work out to your advantage if interest rates keep decreasing while you’re making payments.

Also, the good news is your lender can’t just change your interest rate willy-nilly. Most will have limits for interest rate fluctuations and how often your interest rate can be changed.

In addition, to entice people to get an adjustable-rate mortgage, many lenders will offer an introductory interest rate called a “teaser rate”. You’ll enjoy a lower rate for the first few years and then it’ll start fluctuating. At the most, the rate will change once a year.

An adjustable-rate mortgage is better for people who only plan on staying in their homes for a few years.

Interest-Only Loans

This is a rarer type of mortgage that not many homeowners choose. Still, it’s an option to consider.

Instead of your monthly payments being split between your principal and interest, your initial payments are focused solely on the mortgage interest. Once you’ve paid it off, you’ll then concentrate on the principal, which means you’ll have lower monthly payments.

This is optimal for those with wealth or irregular income. It’s also good if you plan on selling your house after a few years, before you start making hefty monthly payments.

Do note that you won’t build equity in your house if you choose this type of mortgage.

Jumbo Mortgage Loans

Mortgage amounts are set by the Federal Housing Finance Agency (FHFA). This limit is called the conforming loan limit and it’s usually around $548,000. If you need to get a mortgage that’s over this limit, you’ll have to apply for a jumbo mortgage loan.

What’s interesting to note is that jumbo mortgage loans can actually be either fixed-rate or variable-rate mortgages, as well as interest-only loans.

Buy a House With Confidence

Now you know the answer to the question, “how do mortgage rates work”. There are pros and cons to choosing fixed-rate vs variable-rate mortgages, as well as interest-only and jumbo mortgage loans. Not to mention, there are additional pros and cons to picking certain loan term lengths.

It might all feel very overwhelming, so it might be a good idea to speak with a lender or a mortgage advisor. They’ll be able to simplify things even more and answer any questions you might have before you take the plunge.

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