In determining the price of a home, many people only consider the listing price of a home, without considering the cost of interest on a loan used to finance the home. The truth is that you will probably pay a significant amount of interest over the life of your mortgage — but that’s okay. You simply need to be prepared for it.
Interest on any loan, mortgage, credit cards, or otherwise, is the fee you pay to the lender for allowing you to borrow the initial sum of money. The amount of money you actually borrow is called the “principal” on the loan. The interest rate determines the amount you owe on each loan payment and how much you’ll pay over the life of the loan.
The Rate Determines How Much Interest You Pay on Your Mortgage
Getting the lowest interest rate possible is important. The rate determines how expensive your mortgage really is. The lower the interest rate, the lower the fee you pay to borrow money from a lender.
It makes a big impact when you can see how a small change in the rate can change how much interest you owe. Let’s look at a few examples to see how small adjustments can create very different outcomes.
For these examples, we’ll assume this is a conventional mortgage with a 30-year term. Let’s look at how different loan amounts impact the amount of interest you’ll pay on your loan first.
|Loan amount||Interest Rate||Monthly Payment||Interest Paid in Total||Total Cost of Mortgage|
Interest makes the total amount you pay for your home much higher than the actual purchase price. This is why it’s so important to carefully look at your budget and consider what you can really afford to pay over time.
The lender is motivated to let you borrow as much as you can possibly afford. The more you borrow, the more you pay back to them in interest. Only borrow what you need and make sure to save enough for a down payment to reduce the amount of your new home you need to finance (or use a home co-investment).
Now, let’s look at how different interest rates impact the cost of your mortgage.
|Interest Rate||Loan Amount||Monthly Payment||Interest Paid in Total||Total Cost of Mortgage|
Once you determine how much you can truly afford to borrow, getting the lowest interest rate possible is crucial. Even half a percentage point, from 3% to 3.5%, will cost you $100 extra every month — and over the lifetime of your loan, you’ll pay nearly $40,000 more just in interest!
The difference in a full point of mortgage interest is even more dramatic. If you have to pay an interest rate of 4.5% instead of 3.5% on your loan, your monthly payment will cost $230.50 more. The total cost of your mortgage will also be $83,000 higher than the loan with the lower interest rate.
It’s also important to note that the amount you pay in interest each month changes the longer you make payments. Initially, you’ll pay more interest each month. But as you reduce the balance on your loan, your interest payments decrease and the amount you put toward your principal increases.
For example, if you borrow $200,000 at a 4% interest rate, your very first monthly payment will include $666.67 in interest and $288.16 toward the principle. After 5 years of making mortgage payments each month, your monthly payment breaks down into $604.15 in interest charges and $350.68 going to the principle. At 10 years, your interest payment is $526.65 and your principle is $428.18.
Be sure to look at your full amortization schedule to see exactly how much in interest you pay on a monthly basis. Online mortgage calculators can help.
How to Reduce the Interest You Pay on a Mortgage
It’s well worth it to do everything in your power to get a lower interest rate. Doing so means paying less each month, which frees up more money in your cash flow. It also means saving tens of thousands of dollars over the 30 years you make payments on your mortgage.
In general, interest rates are determined by market conditions and the economy. You can’t control that — but you can take action to qualify for the lowest interest rates lenders currently offer.
Charging interest is how lenders make money on the loans they originate. And lending money is risky, because there’s always a chance a borrower may stop making payments or fail to repay a loan. Lenders only offer the lowest mortgage rates to people who pose the lowest risk of not making payments or defaulting on their mortgages.
To reduce the interest you need to pay on your mortgage, you need to show the lender you’re a low-risk borrower. Here are a few ways to do that:
- Put more money down. A larger down payment means you finance less of the purchase, which means you pose less of a risk to the lender. You’ll have a smaller loan amount and smaller monthly payments.
- Show proof of steady income and low debt. Lenders want to know you can reasonably afford to repay your loan. They look for consistent, reliable sources of income that you can use to make your payments. And if you have little to no debt, you have more cash available to pay your mortgage with.
- Maintain a good credit score. A credit score is a measure of how creditworthy you are, and is another metric lenders use to assess risk. Credit reporting agencies calculate scores based on predictive data. Their research indicates that if someone has a history of late or missed payments, for example, they are more likely to miss or not make payments at all in the future. Their credit score will be lower as a result, and a lender will see that person as higher-risk than a borrower with a good credit score. The higher your credit score, the lower interest rates you can qualify for.
You can also reduce the amount of interest you pay over time by making extra payments on your mortgage. So even if you can’t qualify for the lowest interest rate, you can save money by paying down the balance faster.
Remember, interest is simply the cost of borrowing money from the lender. Understanding how interest works — and how you can reduce it — can allow you to better prepare your home-buying budget.