Investment Glossary – Mortgage Rate

There’s no free lunch. When it comes to buying a house, there’s no free money either. The mortgage rate is the rate of interest a bank or other lender charges on a loan to buy a piece of real estate. The interest they charge is wrapped into your monthly payment, made up of principal and interest, with that monthly payment amount determined by the amortization schedule of the mortgage. So what does that actually mean?

When most people buy a home, they don’t have enough money to pay for it up front. So instead, they make a down payment of a portion of the price, and then take out a mortgage to borrow the rest, with the intention of paying that mortgage back over time. Since banks are in the business of making money, they charge interest on that loan, because otherwise, they would have invested that money elsewhere where they could generate a better return than simply lending you the money for free.

The mortgage rate is the specific rate of interest that the bank charges you on that loan.

Typically, most mortgages have a fixed interest rate that does not change over the course of the loan. However, some borrowers will choose an adjustable-rate mortgage (ARM), in which the rate may be fixed initially, but can then change as you go through the repayment period. Through the amortization process, the amount of principal and interest you pay on a monthly basis is determined by the bank, with the payment remaining the same for periods when the mortgage rate is the same. With an ARM, if the mortgage rate increases, the amount you pay on a monthly basis is likely to increase as well, and this is a key consideration you need to keep in mind if you are taking out an ARM.

Mortgage rates are typically set by banks in comparison to other interest rates out there, most notably United States treasury bonds. While it is not always the case, the 10-year treasury bond is one of the most widely-watched instruments out there when it comes to mortgage rates, as this is used by many banks as a benchmark for fixed-rate mortgages. ARMs may use other benchmarks, and different banks may have slightly different formulas for calculating mortgage rates, which is part of the reason you may see different offers from different banks.

The mortgage rate is a key part of deciding how much you should spend on a home, as that rate helps determine what your monthly payment is, which is critical when determining affordability. Rate increases can turn a home that was previously affordable into one that no longer makes financial sense, so it’s important to pay attention to the mortgage rates being discussed by lenders as you make your way through the home-buying process.

If you’re interested in a more in-depth look at how mortgage rates can affect your ability to buy a home, our guide on home-buying basics may help. Click here to download it.