What is Interest Rate?

An interest rate is the percentage a lender charges a borrower for the use of assets, calculated as an annual percentage of the outstanding loan principal. In the context of a home mortgage, the interest rate represents the base cost of borrowing before accounting for other administrative fees or closing costs. The specific rate assigned to a loan is determined by a combination of macroeconomic indicators (such as the Federal Reserve’s monetary policy, inflation forecasts, and investor demand for mortgage-backed securities (MBS)) and individual borrower risk metrics, including the credit score, debt-to-income (DTI) ratio, and loan-to-value (LTV) ratio.

Mortgages can be structured with fixed or adjustable interest rates. A fixed-rate mortgage preserves the identical interest rate, and therefore a predictable principal and interest payment, throughout the entire life of the loan. An adjustable-rate mortgage (ARM) features an initial fixed-rate period followed by periodic rate adjustments tied to a benchmark index, such as the Secured Overnight Financing Rate (SOFR). To manage rate fluctuations during the home buying process, borrowers can lock in a rate for a specified timeframe (typically 30 to 60 days). Additionally, borrowers can pay discount points (prepaid interest) at closing to secure a lower interest rate, or receive lender credits (which raise the interest rate) to offset upfront closing costs.