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What Are Mortgage Rates and How Do They Work?

Posted by Vanessa Freeman on May 8, 2018

What Are Mortgage Rates and How Do They Work Concept Featured ImageWhen you apply for a mortgage, you know you’re going to have to pay interest and the interest rate will affect your monthly payment. Beyond that, you might struggle to understand just how much difference a mortgage rate can make and whether or not you’re getting the best deal. 

It sounds complicated, but the more you know, the easier it becomes to make a decision.

Mortgage Rate vs. APR

The bank quotes you a mortgage rate, but what gets confusing is the rate is compounded semi-annually rather than monthly, so the actual interest rate you’re paying is usually slightly higher. This is your effective rate. You can also look at the annual percentage rate (APR). This gives you a better picture of the mortgage rate over the lifetime of the loan because it includes any discounts you might get. Two different lenders might show you the same interest rate, but the APRs might be different. That’s why it’s smart to get both figures so you can accurately compare your offers.

Variable vs. Fixed-Rate Mortgages

What Are Mortgage Rates and How Do They Work Phone ImageEdmontonians can take out mortgages with variable or fixed rates. A fixed-rate mortgage stays the same for the entire duration of the loan, but a variable rate mortgage changes the rate after a certain period. The rate changes based on Edmonton's real estate market, so it’s possible your variable interest rate could go down. Usually, though, the interest rate increases. If there’s a big increase in the rate, you’ll see a big increase in your monthly payment, and this can make your mortgage less affordable. Most home buyers prefer the certainty of a fixed-rate mortgage, but some people are attracted to the lower initial rates offered with the variable rate.

What Affects Your Mortgage Rate

Your credit score is going to play the biggest role in determining your interest rate. People with better credit qualify for lower interest rates. Banks usually determine this based on ranges. For instance, they might say those with credit scores between 650 and 750 will pay a 6 percent rate on mortgages, while those with scores 750 and higher will pay 5.5 percent. If your score is at the upper end of their range, you might want to wait a few months and work on improving your credit score. The difference in interest rates may look small, but it has a much bigger impact long-term.

The lender you choose can also play a role. If your credit score is 745, you’d pay the 6 percent interest in the example above. A different lender might have those with a credit score of 745 in a higher tier with a lower rate. That’s why it always pays to compare lenders.

You’ll also find lower interest rates when you take a shorter term on your mortgage. A 15-year mortgage, for instance, will have a rate that’s about 1 percent lower than the rate on a 25-year mortgage.

Lowering Mortgage Rate with Points

Most lenders will allow you to lower your mortgage rate by paying “points” on closing day. This is an amount equal to 1 percent of the borrowed amount, and it might decrease the mortgage rate by a quarter of a percentage point. Paying for two points, then, would get you a half of a percentage point discount. Doing this requires money up front, but it will lower your monthly payment a bit and decrease the overall cost of the loan by tens of thousands of dollars.

Mortgage Amortization and Your Monthly Payment

Many buyers make the mistake of thinking the monthly mortgage payment is divided evenly between principal and interest, but this isn’t the case. Banks use an amortization schedule to charge interest. In the early years, almost the entire monthly payment goes toward interest, but about halfway through, the balance shifts and you start paying more money toward the principal. If you’re able to add some extra money to your monthly payment, that will go toward the principal balance. Eventually, you’ll pay off your mortgage sooner this way.

Choosing the Right Mortgage for You

Ultimately, you have to look at all of the numbers and find a mortgage that's right for your family. Start by finding a monthly payment that’s affordable. Remember, something that’s at the upper limit of your comfort level could become a tighter squeeze when you have a financial setback like job loss. 

Compare rates from a few different lenders. Look at monthly payments and APR. For some families, the lower monthly payment might be more attractive even if this means a slightly higher APR. A good lender can help you sort through the options and answer any questions you may have.

Choosing a mortgage lender and the right type of mortgage loan for you can be difficult, but if you remain focused on your family’s priorities, you’ll choose the right one.

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Topics: mortgage & financial