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You know you have to shop for the best mortgage rate when buying or refinancing a home. You’ve heard that time and time again. But do you know how mortgage rates work? You will by the time you finish reading this two-part tutorial.

Let’s Start With a Definition

A mortgage rate is the amount of interest charged on a home loan. It is cost of the loan, above and beyond the principal amount that is being borrowed. The mortgage rate is typically expressed as a percentage of the loan amount. A borrower with a mortgage rate of 5% will pay 5% of the principal balance each year — divided over 12 monthly payments, in most cases.

Lenders charge interest partly to generate a profit on the loans they make, and partly to cover their operating costs. It is one of the two primary ways they make money. Charging fees is the other way.

The mortgage rate is not the same as the annual percentage rate (APR). The APR, which is also expressed as a percentage, shows the full cost of your home loan on a yearly basis. The APR includes the interest charged by the lender plus other loan-related costs, such as discount points, origination fees, mortgage insurance, and most of your closing costs. Your monthly loan payments are based on your mortgage interest rate — not the APR.

How Do Mortgage Rates Work?

In a typical mortgage scenario, the interest is computed and paid on a monthly basis. So you could divide the annual rate by 12 to see how much interest you will pay each month. For example, let’s assume I have an annual mortgage interest rate of 5.2%. If I divide that by 12 (for the number of months in a year), I would get 0.43%. So each month, I will pay 0.43% interest on my principal balance.

Mortgage rates can be either fixed or adjustable / variable. Here’s the difference:

  • Fixed: As the name implies, a fixed rate stays the same over the entire term of the loan, even if the term is 30 years. As a result, the monthly payments stay the same for the full term of the loan.
  • Adjustable: An adjustable or variable rate changes at a predetermined interval, following the up or down movements of a particular index. They are often “tied” to the London Interbank Offered Rate (LIBOR), or the 11th District Cost of Funds Index (COFI). These home loans are referred to as adjustable-rate mortgages, or ARMs.

So, how do mortgage rates work for ARM loans? Most ARMs start off with a fixed interest rate for a certain period of time, such as five years. This is referred to as the initial period. After the initial period, the rate will begin to change at regular, predetermined intervals. A 5/1 ARM loan, for example, has a fixed mortgage rate for the first five years (as indicated by the first number). After that, it will adjust every year (as indicated by the second number).

Read our ARM loan tutorial to learn more about this subject.

Mortgage loans amortize over time. Amortization is the gradual reduction in a debt when regular payments are made. As you make your monthly payments, your home loan will gradually amortize (or reduce) until it is fully paid off. Unless, of course, you refinance or sell the home before the loan’s term expires.

When a lender offers you a mortgage rate, they should also provide an amortization table that shows how your loan amortizes over time. During the early years of the term, most of your monthly payment will go toward the interest. So you don’t reduce your principal very quickly in the early years. But this changes over time. Toward the end of the loan’s term, most of the monthly payment will be applied to the principal. So you will pay down your principal more quickly in the later years. This is the typical pattern of amortization for home loans.

PITI and Monthly Payments

So, how do mortgage rates work on a monthly basis? How do they affect your monthly loan payments? This is where we need to talk about PITI (pronounced pity).

Your monthly mortgage payments will consist of four primary components:

  • Principal — This is the actual amount you borrow from the lender, excluding interest and fees.
  • Interest — The amount of interest you pay each month, as a result of your mortgage rate.
  • Taxes — Your monthly property tax payment (yes, it gets rolled into your monthly payment).
  • Insurance — Your homeowner’s insurance premium (a.k.a., hazard insurance).

These four items are collectively referred to as PITI, an acronym derived by the first letter of each item.

So you can see how mortgage rates work on a monthly basis. They are one of the four components that make up your monthly payments. With a fixed-rate mortgage, defined previously, the size of the monthly payment will remain the same for the entire term of the loan. That’s because the amount of interest charged every month stays the same. With an adjustable-rate mortgage, or ARM, the monthly payments can go up or down over time, as the interest rate adjusts.

Paying Points to Lower Your Mortgage Rate

Now that you know how mortgage rates work, let’s talk about what you can do to get a lower rate from the lender.

First-time home buyers are often surprised by the total amount of interest paid on a mortgage loan, over the full term of the loan. Depending on the rate you receive from the lender, you could end up paying as much (or more) in interest than you pay in principal.

Consider the following example:

  • Loan amount: $200,000
  • Interest rate: 6%
  • Loan term: 30 years
  • Total interest paid after 30 years: $231,676

In this real-world scenario, the borrower will pay more money in interest over 30 years (($231,676) than he or she pays in principal ($200,000). So the full cost of the loan, excluding property taxes and home insurance, is more than $430,000. This is why it’s so important to understand how mortgage rates work. They can have a tremendous impact on the full cost of your loan, especially if you hold it for a long period of time.

There are certain things you can do to reduce the amount of interest paid over the term. Paying discount points is one such strategy. A mortgage discount point is a form of prepaid interest. One point equals one percent of the loan amount (e.g., $2,000 on a $200,000 home loan). As a borrower, you can pay points at closing to “buy down” the mortgage rate. The exact amount of the reduction will vary from lender to lender. On average, one point paid at closing will reduce the mortgage interest rate by 0.25%.

Learn more: Should I pay discount points on my loan?

This strategy is a tradeoff. You are paying more money up front, in total closing costs. But you could end up paying a lot less over the full term of the loan. Depending on how long you plan to keep the loan, this may or may not be a wise strategy. The key here is to understand how mortgage rates work, and what you can do to reduce them. Discount points are one way to reduce your total interest costs.

Part 2: In the next part of this tutorial, you’ll learn how lenders determine your mortgage rate. (Hint: It has everything to do with risk.)