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What is mortgage interest, and how does it work?

Yahoo Personal Finance· Getty Images
Rachel Witkowski
5 min read

Every time you make a monthly mortgage payment, you’ll put money toward both the mortgage principal (or your loan amount) and the mortgage interest.

Mortgage interest is the fee you pay for borrowing from your mortgage lender, similar to interest you’d pay on a personal or student loan. The mortgage interest rate varies depending on the length of your mortgage term, the amount you borrow, and market rates in your area. Although interest charges can quickly add up, you may be able to deduct mortgage interest payments when you file your income taxes.

You should consider all of these factors before buying a house and locking in your mortgage rate.

Read more: Best mortgage lenders for first-time buyers

Mortgage interest is the fee for taking out a home loan, expressed as a percentage. Three main factors determine what mortgage interest rate a lender offers you:

  • The mortgage principal. This is your loan amount. You may get a lower interest rate if you have a larger down payment (thus requiring you to borrow less).

  • The loan term. A mortgage loan term is the lifespan of your loan, such as a 15-year or 30-year mortgage. Lenders charge lower rates for shorter terms — for example, you might pay 7% on a 30-year mortgage but 6% on a 15-year mortgage. You’ll also pay less over the life of your loan with shorter terms because there will be less time for interest to accumulate.

  • Your financial situation. When determining your interest rate, lenders look at factors like your credit score, employment history, and debt-to-income ratio. The stronger your finances, the lower your rate should be. Why? Because lenders tend to charge lower rates to less risky borrowers.

You can get either a fixed-rate mortgage that keeps your rate the same for the entire term or an adjustable-rate mortgage that changes your rate periodically.

Your monthly mortgage payment consists of interest, principal, and other expenses, including mortgage insurance, property taxes, and homeowners insurance.

Interest also compounds on a mortgage loan, meaning you pay interest on both the principal and the interest that has already accumulated. This is why you end up paying so much in interest over the years. You’d pay much less if it were simple interest.

Learn more: What does PITI mean, and how does it affect your mortgage?

With mortgages, you follow an amortization schedule, which means you pay in monthly installments until the balance reaches $0. If you have a fixed-rate mortgage, the monthly payments toward your principal and interest will stay the same throughout the term, but most of that money will pay for interest at first. Over time, more and more of those payments will go toward the principal and less toward interest.

Once you are approved for a mortgage, the lender will give you a loan estimate detailing your overall loan costs and expected monthly payments, including the principal and mortgage interest. But to help you figure it out on your own, here’s an example of how to calculate your mortgage interest payments:

  • Take your annual interest rate and divide it by 12 (for 12 months in a year)

  • Multiply that outcome by the outstanding balance on your loan

Let’s say you have a $400,000 mortgage with a 6% interest rate. Using the above calculation, you would divide 0.06 (or 6%) by 12, resulting in 0.005. If this is your first payment, you’d multiply 0.005 by 400,000 and get 2,000. That means you’d pay $2,000 just toward interest in the first month. Meanwhile, roughly $400 would go toward the principal that month.

This basic calculation does not include other mortgage costs like property taxes and homeowners insurance, so it’s critical the lender gives you a loan estimate once you are approved for a mortgage.

Learn more: How much house can I afford?

There is a major benefit to paying mortgage interest: It could be tax deductible when you file your federal income taxes, lowering your overall tax liability. Depending on where you live, you may be able to deduct interest on your state taxes, too.

At the start of the year, your lender will send you a Form 1098 that summarizes your mortgage interest payments for the previous taxable year. This will help when you itemize the mortgage interest paid for a tax deduction.

However, there are some restrictions to claiming the mortgage interest tax deduction. For example, if you opt for a standard deduction rather than an itemized deduction, you cannot take advantage of the mortgage interest tax benefit.

Most homeowners can deduct mortgage interest charges from their taxes, though you do have to meet certain requirements. For example, the IRS limits you to deducting interest paid on the first $750,000 ($375,000 if married filing separately) of mortgage debt for mortgages taken out after Dec. 15, 2017. For homes purchased earlier, you can deduct mortgage interest paid on the first $1 million ($500,000 if married filing separately) of the mortgage.

Dig deeper: Standard deduction vs. itemized — How to decide which tax filing approach is right

The interest rate on a mortgage is essentially the cost of borrowing money from a lender. It is a fee expressed as a percentage, such as 6.5% or 7%, charged on top of the total loan balance, or principal.

Yes, the interest you pay on your mortgage may be tax deductible if it’s your primary or second home and the mortgage is secured by that home. You will need to use Form 1040 to itemize your deductions rather than use the standardized deduction when you file your taxes.

Getting a good mortgage interest rate depends on several factors, including the current market rates compared to the specific rate a lender offers you. That’s why it’s smart to shop around and get quotes from at least three to five mortgage lenders to ensure you’re getting a good deal.

Your mortgage interest rate is primarily based on the length of your mortgage term, the amount you borrow, and your financial situation. Mortgage interest is calculated as a percentage of your loan balance. As your mortgage balance decreases, you pay less in interest each month and more toward the principal.

This article was edited by Laura Grace Tarpley