How Mortgages Work: Interest Rates, Loan Types, and What Affects Your Payment

How a mortgage works

A mortgage is a loan secured by real estate. The property serves as collateral, meaning if the borrower stops making payments, the lender can foreclose and sell the property to recover the debt.

The borrower receives a lump sum to purchase the home and repays it over time with interest. Monthly payments typically include:

• Principal: The portion that reduces the loan balance
• Interest: The cost of borrowing, paid to the lender
• Property taxes: Often collected monthly and held in escrow
• Homeowners insurance: Also often escrowed
• PMI: Private mortgage insurance, if applicable

The total monthly payment is often called PITI (principal, interest, taxes, insurance).

How Mortgage Rates Change Over Time

As of February 2026, 30-year fixed mortgage rates average around 6%, down from peaks above 7% in early 2025. The 15-year fixed rate averages approximately 5.35%.

Rates vary significantly based on individual factors. A borrower with excellent credit and a large down payment might secure a rate 0.5% lower than average. Someone with marginal credit or a small down payment might pay 0.5-1% more.

The Federal Reserve's benchmark rate influences mortgage rates indirectly. When the Fed raises rates, mortgage rates tend to follow, though the relationship isn't immediate or proportional.

Fixed-rate vs. adjustable-rate mortgages

Fixed-rate mortgages lock the interest rate for the entire loan term. A 6% rate on day one remains 6% for all 30 years. Monthly principal and interest payments never change (though escrow amounts for taxes and insurance may).

Adjustable-rate mortgages (ARMs) have rates that change after an initial fixed period. A 5/1 ARM fixes the rate for five years, then adjusts annually based on a market index plus a margin.

ARMs typically offer lower initial rates than fixed-rate mortgages. The tradeoff is uncertainty: after the fixed period, rates could rise significantly. Rate caps limit how much the rate can increase per adjustment and over the loan's life, but even capped increases can substantially raise payments.

ARMs make sense when planning to sell or refinance before the adjustment period begins. For long-term homeownership, fixed rates provide certainty.

30-year vs. 15-year terms

The loan term dramatically affects both monthly payments and total interest paid.

Consider a $400,000 loan:

30-year at 6%:

• Monthly payment: $2,398
• Total interest paid: $463,353
• Total cost: $863,353

15-year at 5.35%:

• Monthly payment: $3,243
• Total interest paid: $183,740
• Total cost: $583,740

The 15-year loan costs $845 more monthly but saves $279,613 in interest over the loan's life. The shorter term also builds equity faster.

The 30-year term dominates the market because its lower monthly payment fits more household budgets. The 15-year term suits those who can afford higher payments and prioritize paying less interest overall.

What determines your mortgage rate

Lenders assess risk when setting rates. Lower-risk borrowers receive lower rates.

Credit score: The most significant factor. Scores above 760 typically qualify for the best rates. Below 620, conventional loans become difficult to obtain.

Down payment: Larger down payments reduce lender risk and often secure lower rates. Putting down 20% or more also eliminates the need for private mortgage insurance.

Debt-to-income ratio (DTI): Lenders compare monthly debt payments to gross monthly income. Most conventional loans require DTI below 43%, though some allow higher.

Loan-to-value ratio (LTV): The loan amount divided by the home's appraised value. An 80% LTV (20% down payment) is the threshold for avoiding PMI on conventional loans.

Loan type: Government-backed loans (FHA, VA, USDA) have different rate structures than conventional loans. Jumbo loans for amounts exceeding conforming limits often carry higher rates.

Property type and use: Primary residences receive better rates than investment properties or second homes.

Down payment requirements

Different loan types have different minimum down payments:

Conventional loans: As low as 3% for first-time buyers, though 5-20% is more common. Down payments below 20% require private mortgage insurance.

FHA loans: Minimum 3.5% down with a credit score of 580+, or 10% with scores between 500-579. FHA loans require mortgage insurance for the life of the loan (unless refinanced).

VA loans: No down payment required for eligible veterans and service members. No mortgage insurance required.

USDA loans: No down payment for eligible rural properties. Income limits apply.

A larger down payment reduces the loan amount, lowering monthly payments and total interest. It also demonstrates financial stability to lenders, often resulting in better rates.

Private mortgage insurance (PMI)

PMI protects the lender if the borrower defaults. It's required on conventional loans with less than 20% down.

PMI typically costs 0.5-1% of the loan amount annually, added to monthly payments. On a $400,000 loan, that's $167-$333 monthly.

PMI can be canceled once the loan balance reaches 80% of the original home value. At 78%, lenders must automatically terminate it. Building equity through payments and home appreciation eventually eliminates this cost.

FHA loans have their own mortgage insurance premiums (MIP), which work differently and often remain for the loan's duration.

The loan estimate and closing costs

Within three days of applying for a mortgage, lenders must provide a Loan Estimate detailing the proposed terms. This standardized form shows:

• Interest rate and monthly payment
• Estimated closing costs
• How the rate and costs might change
• Whether the loan has special features (prepayment penalties, balloon payments)

Closing costs typically run 2-5% of the loan amount. They include:

• Origination fees (lender charges)
• Appraisal fee
• Title insurance and search
• Attorney fees
• Recording fees
• Prepaid taxes and insurance

Some costs are fixed; others are negotiable. Comparing Loan Estimates from multiple lenders reveals where costs differ.

Points and rate buydowns

Discount points are upfront fees that lower the interest rate. One point equals 1% of the loan amount and typically reduces the rate by 0.25%.

On a $400,000 loan, one point costs $4,000. If it reduces the rate from 6% to 5.75%, monthly savings are approximately $58. The breakeven point is roughly 69 months, and after that, the buydown saves money.

Points make sense for borrowers planning to keep the loan long-term. For those likely to sell or refinance within a few years, the upfront cost may not be recovered.

Sellers sometimes offer temporary rate buydowns as incentives. A 2-1 buydown, for example, reduces the rate by 2% the first year and 1% the second year, then reverts to the full rate.

How much house can you afford?

Lenders use debt-to-income ratios to determine loan amounts, but approval doesn't equal affordability.

The traditional guideline: housing costs (PITI) shouldn't exceed 28% of gross monthly income, and total debt payments shouldn't exceed 36%. Lenders often approve higher ratios, up to 43% or more, but stretching to the maximum leaves little margin for other expenses or emergencies.

Beyond the mortgage payment, homeownership costs include:

• Maintenance and repairs (budget 1-2% of home value annually)
• Utilities
• HOA fees, if applicable
• Higher insurance costs than renting

The comfortable purchase price depends on income, other debts, savings, job stability, and personal spending priorities.

Shopping for a mortgage

Freddie Mac research indicates borrowers who get quotes from multiple lenders save money. The difference between offers can be substantial, sometimes 0.5% or more in rate.

Shopping doesn't significantly impact credit scores. Multiple mortgage inquiries within a 45-day window count as a single inquiry for scoring purposes.

Compare:

• Interest rates
• APR (includes rate plus fees, showing true cost)
• Closing costs itemized
• Lender fees vs. third-party fees
• Rate lock terms

Pre-approval from a lender provides a specific loan amount based on verified income and credit, strengthening offers when competing for homes.

The bottom line

A mortgage converts a large purchase into manageable monthly payments over decades. The interest rate, loan term, and down payment determine both monthly costs and total interest paid.

Small rate differences compound significantly over 15-30 years. A 0.25% lower rate on a $400,000 loan saves roughly $20,000 over 30 years. Shopping multiple lenders, improving credit before applying, and choosing appropriate loan terms all influence this outcome.

The monthly payment matters for budgeting, but total cost matters for wealth building. Shorter terms and larger down payments cost more monthly while reducing the total price of homeownership.