As you are comparing lenders, mortgage rates and options, it’s helpful to understand how interest accrues each month and is paid. Simply put, every month you pay back a portion of the principal (the amount you’ve borrowed) plus the interest accrued for the month. Your lender will use an amortization formula to create a payment schedule that breaks down each payment into paying off principal and interest. The length, or life, of your loan, also determines how much you’ll pay each month. Stretching out payments over more years (up to 30) will generally result in lower monthly payments. The longer you take to pay off your mortgage, the higher the overall purchase cost for your home will be because you’ll be paying interest for a longer period.
Banks and lenders primarily offer these types of loans:
- Fixed Rate: Interest rate does not change. The monthly payment remains the same for the life of this loan. The interest rate is locked in and does not change. Loans have a repayment life span of 30 years; shorter lengths of 10, 15 or 20 years are also commonly available. Shorter loans will have larger monthly payments that are offset by lower interest rates and lower overall cost.
- Adjustable Rate: Interest rate will change under defined conditions (also called a variable-rate or hybrid loan). Because the interest rate is not locked in, the monthly payment for this type of loan will change over the life of the loan. Most ARMs have a limit or cap on how much the interest rate may fluctuate, as well as how often it can be changed. When the rate goes up or down, the lender recalculates your monthly payment so that you’ll make equal payments until the next rate adjustment occurs.
- Interest-Only Loans: Usually reserved for affluent home buyers or those with irregular incomes. As the name implies, this type of loan gives you the option to pay only interest for the first few years.
You’ll need to budget for other items that will significantly add to the amount of your monthly mortgage payment, such as taxes, insurance, and escrow costs. These costs are not fixed and can fluctuate.
In theory, paying a little extra each month toward reducing principal is one way to own your home faster. Financial professionals recommend that outstanding debt, such as from credit cards or student loans, be paid off first and savings accounts should be well-funded before paying extra each month.
If you itemize deductions on your annual tax return, the Internal Revenue Service allows you to deduct home mortgage interest payments. For state returns, however, the deduction varies. Check with a tax professional for specific advice regarding the qualifying rules, particularly in the wake of the Tax Cuts and Jobs Act of 2017. This law doubled the standard deduction and reduced the amount of mortgage interest (on new mortgages) that is deductible.
This article will explain your mortgage options in more detail.