How Interest Rates Work
March 1, 2022
Interest rates can be a confusing topic for many individuals, especially when they are associated with large loans such as mortgages. Lenders charge interest because of the risk they take on to lend money to borrowers. To fully comprehend interest rates, it is important to also understand compounding interest, amortization, and fixed-rate and adjustable-rate mortgages, among other factors.
Interest is charged as a percentage of the loan amount. The full cost includes interest, fees, and points, if applicable. This is known as annual percentage rate (APR). Common mortgage fees include costs associated with an appraisal, home inspection, loan origination, application, credit report, recording, document preparation, and title insurance, to name a few. Points include costs such as loan origination fees and broker fees. Discount points can also factor into the APR – these can be purchased in exchange for a lower rate in some circumstances.
Compounding interest
When you take out a mortgage, unpaid interest accrues on the balance every month. For example, if you have a mortgage for $200,000 over 30 years with an interest rate of 4.5%, you would not pay 4.5% of $200,000 in interest. Rather, you would pay interest on the remaining balance after each monthly payment. A mortgage calculator is provided on the Mlend website to help you calculate what your monthly payment might be after factoring in the cost of the home, down payment, interest rate, mortgage term, and other factors such as taxes, insurance, and HOA fees.
Amortization
Amortization makes the concept of compounding interest a little easier to understand. This is the process of making mortgage payments to pay off your principal and interest until they both reach zero. If you have a fixed-rate mortgage, which we will explain in greater detail in the next section, your mortgage payment will be the same every month. However, the amount that goes towards principal and interest will change each month. The amount you owe in interest will be highest on the very first payment you make, and it will be lowest on the last payment you make. In contrast, the first payment you make will be comprised of the lowest percentage of money towards the principal, and the last payment will be the highest amount designated to principal. Policygenius provides a helpful visual example of amortization over certain points in the life of a 30-year mortgage.
Fixed-rate and adjustable-rate mortgages (ARM)
In the case of a fixed-rate mortgage, the rate will stay the same for the life of the loan. In comparison, an adjustable-rate mortgage (ARM) is subject to increase and/or decrease based on market indexes. Many ARMs offer a certain number of years at the beginning of the mortgage in which there will be a fixed interest rate, such as a 7/1 ARM, which provides a fixed rate for the first seven years and an adjustable rate for the remainder of the mortgage.
It is important to factor in interest rates as you look at homes and prepare to apply for a mortgage. You may receive a different rate than what you expect, and you will want to make sure that your mortgage costs fit in with your monthly budget. Mlend is here to answer any question that may come to mind as you navigate the mortgage process.