How Mortgage Interest Works

Posted on April 09, 2024

Key Takeaways:

The Federal Reserve System doesn’t set mortgage interest rates but has a strong influence on them because the Fed does set the federal funds target rate that banks are expected to follow.
The Fed raises the federal funds rate to fight inflation and lowers it to boost employment.
With a fixed-rate mortgage, you can lock in a rate for the life of your loan, even if market rates go up.
With an adjustable-rate mortgage, you may be able to get a lower initial interest rate, but it may increase at the time of reset, depending on market conditions.

When you borrow money to buy a home, you make payments on the interest every month as part of your monthly mortgage payment, which also includes:

Principal
Insurance
Escrow to pay property taxes and insurance (usually)

A higher interest rate means more of your monthly payment will go toward paying interest on the loan, rather than paying down the loan balance. That said, the total monthly amount may still be lower than renting, depending on where you live. Check out our Rent vs. Buy calculator for a quick comparison.

Who sets mortgage interest rates?

Mortgage lenders set the mortgage interest rates, and those rates are typically based on the bond market or the federal funds target rate set by the Federal Reserve System (the Fed).

The federal funds target rate is the interest rate banks pay to borrow money from each other overnight in order to maintain the level of reserves required by law.

What affects the federal funds target rate?

Within the Fed, the Federal Open Market Committee (FOMC) meets eight times a year to set the federal funds rate. Their goals are to:

Keep prices stable
Maximize employment

As a general rule, the Fed raises interest rates in times of inflation and lowers interest rates in times of unemployment. Consider two common scenarios.

Inflation: Prices rise quickly, leaving consumers with less buying power. The Fed raises interest rates to reduce demand and get prices back in line.
Unemployment: Unemployment spikes, making employers more hesitant to invest in hiring and consumers more cautious about spending. The Fed lowers interest rates to stimulate the economy.

Fixed-rate versus adjustable-rate mortgages

With a fixed-rate mortgage, your interest rate is locked in for the life of your loan, even if interest rates go up—or down—over time. Many people opt for a fixed-rate mortgage so they don’t have to worry about the potential of interest rates going up and raising the amount of their monthly payments.

With an adjustable-rate mortgage (ARM), the interest rate is usually lower than a fixed-rate mortgage for the first seven to 10 years. After that, the rate is reviewed on a set schedule, often every six months, and it may go up significantly over time. An ARM may be a good choice for someone who is interested in a lower rate, especially if you plan to sell the home before the mortgage interest adjusts or think there’s a good chance you could refinance in the next few years for a better, fixed rate.

Keeping interest rates in context

While high interest rates have been front page news for the last couple of years, this isn’t the whole story. Nationwide, mortgage interest rates have risen, but are still historically low. The peak for 30-year fixed mortgage interest rates was 19% in 1981, according to Freddie Mac.

When you’re ready to apply for a mortgage, United Community is here to answer all your questions. Contact our team or start your secure, digital application now.