Mortgage Interest

What Is Mortgage Interest?

The term mortgage interest is the interest charged on a loan used to purchase a piece of property. The amount of interest owed is calculated as a percentage of the total amount of the mortgage issued by the lender. Mortgage interest compounds and may be either fixed or variable. The majority of a borrower's payment goes toward mortgage interest in the earlier part of the loan.

How Mortgage Interest Works

Most consumers require a mortgage in order to finance the purchase of a home or other piece of property. Under a mortgage agreement, the borrower agrees to make regular payments to the lender for a specific number of years until the loan is either repaid in full or it is refinanced. The mortgage payment includes a principal portion plus interest. Mortgage interest is charged for both primary and secondary loans, home equity loans, lines of credit (LOCs), and as long as the residence is used to secure the loan.

As mentioned above, mortgage interest is calculated as a certain percentage of the mortgage loan. Some mortgages come with fixed-interest rates while others have variable interest rates. More information on these types of rates is outlined below. Mortgage payments are divided into principal and interest. During the earlier part of the mortgage loan, the majority of a property owner's payment goes toward interest versus the principal balance. As the age of the loan increases, more of the payment is applied to the principal balance until it's completely paid off.

Mortgage interest compounds. This means the interest accrues on the principal balance and it also includes any accumulated interest that remains unpaid. So if a borrower makes a late payment on a mortgage, they will have to pay interest on the interest as well. This is the opposite of a simple interest loan, where interest never accrues.

Special Considerations

Mortgage interest is one of the major deductions available to personal taxpayers. Taking this deduction means taxpayers can lower their taxable income for the year. But they must itemize their deductions rather than take the standard deduction option. And there are certain conditions borrowers must meet in order to qualify for the deduction.

Only the mortgage interest on the first $1 million of a first or second home purchase is deductible. For properties purchased after Dec. 15, 2017, mortgage interest on the first $750,000 qualifies for the deduction. Taxpayers can claim the deductible interest on Schedule A of Form 1040.

Mortgage interest can be deducted on the first $750,000 for properties purchased after Dec. 15, 2017.

As long as the homeowners meet the criteria set by the Internal Revenue Service (IRS), the full amount of the mortgage interest paid during the tax year can be deducted. Keep in mind that the mortgage interest can only be deducted if the mortgage is a secured debt, where the home is put up as collateral. The mortgage must also be for a residence that is a qualified home, meaning it is the owner’s primary home or a second home, with certain stipulations on its usage when not occupied by the owner.

Types of Mortgage Interest

A fixed-rate of interest remains constant for a specific period of time or for the entire length of the mortgage loan. Consumers who want predictability in their payments prefer fixed mortgage interest options because they don't come with the highs and lows associated with floating or variable rates. Many mortgagors opt for fixed rates when interest rates are low because if rates go up, their interest rate stays the same. Fixed rates are frequently seen with long-term financing that carries a term as long as 30 years.

Using a mortgage calculator is a good resource to see these costs.

Variable mortgage interest rates change based on the market. These rates are also called floating or adjustable rates. They are based on a benchmark index or interest rate and go up or down based on fluctuations in the market. This means when the underlying index or rate changes, the variable interest rate changes as well. So a mortgagor's payment decreases when the rate drops and increases when rates rise. Variable mortgage interest rates are great options for short-term financing or when a consumer plans to refinance after a certain period of time.