How Mortgage Interest Rates Work: A Guide for California Consumers

You probably understand the importance of getting a good mortgage rate when buying or refinancing a home in California. But do you know how mortgage rates actually work? You soon will.

In this California consumer guide, we will talk about what mortgage rates are, where they come from, and how they affect you as a borrower.

The Mortgage Rate Defined

A mortgage rate is the amount of interest charged on a home loan. It is “cost” of the loan, above and beyond the principal amount that is being borrowed.

In California, mortgage rates are typically expressed as a percentage of the base loan amount. For example: a borrower with a mortgage rate of 5% will pay 5% of the principal balance each year (divided over 12 monthly payments, in most cases).

The mortgage rate is not the same as the annual percentage rate (APR). The APR, which is also expressed as a percentage, shows the full cost of your home loan on a yearly basis. The APR includes the interest charged by the lender plus other loan-related costs, such as discount points, origination fees, etc.

Fixed vs. Adjustable Loans

In a typical mortgage scenario in California, the interest is computed and paid on a monthly basis. So you could divide the annual rate by 12 to see how much interest you will pay each month.

For example, let’s assume I have an annual mortgage interest rate of 5.2%. If I divide that by 12 (for the number of months in a year), I would get 0.43%. So each month, I will pay 0.43% interest on my principal balance.

Mortgage rates can be either fixed or adjustable / variable. Here’s the difference:

• Fixed: As the name implies, a fixed rate stays the same over the entire term of the loan, even if the term is 30 years. As a result, the monthly payments don’t fluctuate very much — if at all.
• Adjustable: An adjustable or variable rate changes at a predetermined interval, following the up or down movements of a particular index. They are often “tied” to the London Interbank Offered Rate (LIBOR), or the 11th District Cost of Funds Index (COFI). These are known as adjustable-rate mortgages, or ARMs.

In California, most ARM loans start off with a fixed interest rate for a certain period of time, such as five years. This is referred to as the initial period. After the initial period, the rate will begin to change at regular, predetermined intervals.

A 5/1 ARM loan, for example, has a fixed mortgage rate for the first five years (as indicated by the first number). After that, it will adjust every year (as indicated by the second number).

Related: Types of home loans in California

Amortization: The Gradual Reduction of Debt

California mortgage loans “amortize” over time. Amortization is the gradual reduction in a debt when regular payments are made.

As you make your monthly mortgage payments, your home loan will gradually amortize (or reduce) until it is fully paid off. Unless, of course, you refinance or sell the home before the loan’s term expires.

During the early years of the term, most of your monthly payment will go toward the interest. So you don’t reduce your principal very quickly in the early years. But this changes over time.

Toward the end of the loan’s term, most of the monthly payment will be applied to the principal. So you will pay down your principal more quickly in the later years. This is the typical pattern of amortization for home loans in California.

PITI and Monthly Payments

So, how do California mortgage rates work on a monthly basis? How do they affect your monthly loan payments? This is where we need to talk about PITI, which is pronounced pity.

Your monthly mortgage payments will (likely) consist of four components:

• Principal — The actual amount you borrow from the lender, excluding interest and fees
• Interest — The amount of interest you pay each month, as a result of your mortgage rate
• Taxes — Your monthly property tax payment (it can be rolled into your monthly payment)
• Insurance — Your homeowner’s insurance premium (a.k.a., hazard insurance)

These four items are collectively referred to as PITI, an acronym derived by the first letter of each item.

Need a Mortgage Loan in California?

This guide explains how mortgage rates work in California. It provides a basic overview attended for a general audience. But portions of this article might not apply to your particular situation. You might also have questions that were not answered above.

In such cases, it’s helpful to talk to a knowledgeable mortgage broker or loan officer. We are located in the Bay Area but serve borrowers all across the state of California. Please contact us if you mortgage-related questions or would like to apply for a loan.