What is Mortgage Interest? And how does it affect your House Payment

In our short young adult years we have bought two homes, three cars, and paid off tens of thousands in debt. And we have written about this topic for the better part of 5 years now. We are experts at financing and how their interest is applied. 

Now personal loan, auto interest and mortgage interest are very different. Mortgage is where we’re focusing today and (in my opinion) is way less complex both in its concept and its calculation. 

Here’s mortgage interest in definition, types, calculations and how to not get caught paying too much. 

What is Mortgage Interest?

Like all interest mortgage interest is the fee you pay for financing.

The Two Main Types of Mortgage Interest Rates

Choosing the right interest rate for your home loan is a bit like choosing a meal from a vast menu—what works for you might not work for someone else. But fear not, we're here to break down the options and help you make a choice that leaves you satisfied.

Fixed-rate Mortgages: Stability and Predictability

Fixed-rate mortgages are the comfort food of the home loan world. Just like your favorite dish, they offer a sense of security because the interest rate stays the same throughout the life of the loan. 

Whether it's for 15, 20, or 30 years, your monthly payments on principal and interest won't change. This predictability makes budgeting a breeze, as you'll always know what your payment is without the worry of future interest rate hikes.

Adjustable-rate Mortgages (ARMs): Flexibility and Risk

On the other side of the menu, we have adjustable-rate mortgages (ARMs), which are a bit like trying a new trendy dish—you might get more flavor, but there's also more uncertainty. 

ARMs offer lower interest rates initially, which makes them attractive to borrowers looking to save money in the short term. 

However, the rate can change over time based on market conditions, meaning your payments could increase or decrease. This option requires a taste for risk and a flexible financial situation.

Which Type of Mortgage Rate is Best?

If you’re asking me, my expert opinion is go with the Fixed rate. Fixed rates offer peace of mind and easy budgeting, making them ideal for those who value stability and plan to stay put for the long haul.

ARMs can be more appealing if you're looking for lower initial payments and are comfortable with the possibility of rates changing over time. But since uncertainty isn’t the best for a long term loan (like a mortgage) this can be disastrous. 

An example of a adjustable rate mortgage gone wrong

Let's explore an example where an Adjustable-Rate Mortgage (ARM) doesn't pan out as hoped on a 30-year mortgage.

Imagine you're excited to buy your first home. You've found the perfect place, but to keep your initial monthly payments manageable, you opt for a 5/1 ARM with a starting interest rate of 3%. 

This rate is fixed for the first five years, which sounds great because it's lower than the fixed rates available at the time. You're thinking you'll save some money, maybe refinance later, or perhaps your income will increase by the time the rate adjusts.

Fast forward five years, and the economy has shifted. Interest rates have climbed significantly due to inflation and other economic factors. Now, your mortgage is set to adjust annually, and the new rate jumps to 6%, effectively doubling the interest portion of your monthly payments.

You find this increase a giant pain in the a$$ because your income hasn't grown as expected, and refinancing now means accepting an even higher fixed rate than the ARM's adjusted rate.

(You see where we're going with this…)

This spike in your monthly payment puts a strain on your budget, forcing you to cut back on other expenses or dip into savings to keep up with mortgage payments. The flexibility and initial savings of the ARM, which once seemed like a smart financial move, now feel like a risky gamble that didn't pay off.

Bottom line, go with the fixed rate.

How Interest is Calculated on Home Loans

Navigating the world of home loans can sometimes feel like trying to solve a puzzle with pieces that don't quite fit.

But don't worry, we're here to help you see the big picture (and it’s a big picture) especially when it comes to understanding how interest is calculated on your home loan.

It's a vital piece of knowledge that can save you a lot of money and confusion down the road.

Principle of Interest Calculation

At its core, the principle of interest calculation on home loans is straightforward. The interest is the cost you pay to the lender for borrowing their money to purchase your home.

It's calculated based on the outstanding balance of your loan. Essentially, the more you owe, the more interest you pay. As you pay down your loan over time, the interest portion of your payment decreases, and the portion that goes toward reducing the loan balance (principal) increases.

Daily Interest vs. Monthly Interest: What’s the Difference?

• Daily Interest: Some lenders calculate interest daily, which means they take your annual interest rate, divide it by 365 (days in the year), and apply it to your loan balance every day. The total interest for the month is then added up and charged on your monthly payment. This method can be beneficial if you make extra payments mid-month, as it reduces your balance and, consequently, the daily interest calculation more quickly.
• Monthly Interest: More commonly, lenders calculate interest monthly. They take the annual interest rate, divide it by 12 (months in the year), and apply it to your loan balance to find out how much interest you owe each month. This calculation is straightforward and makes it easier to predict your monthly expenses, but it doesn't offer the same immediate benefits from extra mid-month payments as the daily calculation does.

How does mortgage interest affect your monthly house payments?

Mortgage interest affects your monthly payment a ton! And so does property taxes (but that’s for another day).

It shapes both the total amount you'll pay each month and the composition of those payments over the life of the loan.

Here's how it works:

When you start paying off your mortgage, the loan balance is at its highest, which means a larger portion of your monthly payment is allocated toward interest, based on the interest rate of your loan. As you continue to make payments, a process known as amortization occurs, where the loan balance gradually decreases, and with it, the interest portion of your payment decreases as well. Consequently, more of your payment goes toward reducing the principal balance over time.

In the early years of a mortgage, it can feel like you're not making much progress on paying down the principal because so much of your payment is going toward interest. However, as you chip away at the loan balance, the interest cost decreases, and you start making faster progress on the principal.

This effect is most pronounced in fixed-rate mortgages, where the total monthly payment (principal and interest combined) remains the same throughout the loan term, leading to a gradual shift in how the payment is split between interest and principal.