Understanding interest rates

You may be a little perplexed about how mortgage interest rates are set. For one thing, you'll discover that the cost of borrowing may vary from lender to lender. Each lender determines the interest rate it charges on a loan — just as two grocery stores might charge different prices for an apple. Further, a lender may change the rates charged frequently, though the day-to-day or week-to-week movements may not be very noticeable.

Why rates change

The big reason rates change is that they reflect the cost of borrowing in the economy as a whole. Typically, when interest rates in general are low, lenders also pay lower rates on the money they have to borrow to lend to home buyers — these lower rates are then passed on to you. Alternately, when rates in general are higher, the lenders' costs to borrow money (to lend to home buyers) also are higher, which are then passed on to you. That matters to you, because the rates that are available when you're ready to buy make a difference in the home you can afford.

If you can spend around $950 on principal and interest each month when rates are 6.5%, you can probably borrow $150,000 for 30 years. But if the rate was as high as 9%, that same $950 would let you borrow closer to $115,000. Lower rates typically mean you can buy a more expensive home.

The other thing that affects the rate you're offered is your credit score. Lenders take your borrowing record into account when they offer you a mortgage. If you have great credit, you're likely to receive the lowest rates the lender has to offer. But you may find a lot of variety in the rates you're offered. So to get the best deal, you may need to shop around. 

Prepaying interest

Sometimes lenders offer you the option to prepay some of the interest on your mortgage at the time you buy. Prepaying interest sometimes takes the form of paying a discount point, or prepaid interest that results in a lower interest rate, in addition to or instead of an origination point, which is usually a fee paid to a lender or mortgage broker for setting up your loan. Often, these terms are shortened simply to points — and each point is 1% of the principal. So if you were taking a loan of $125,000 with two points (one discount point and one origination point) you'd prepay $2,500.

Prepaying may sound like a bad thing, but that's not really the case. Each discount point you pay typically reduces your long-term rate by a fraction of a percentage point. A lower rate means you can actually end up paying less to borrow if you keep your home for a number of years. (The actual time required to break even and begin to save will vary based on the number of points and the reduction in rate.) And you may be able to deduct the prepaid interest when you file your tax return for the year in which you buy your home.