Exploring How Interest Rates Work
Mortgage lenders often make their interest rates highly visible, but they rarely explain how these rates work. For instance, let’s say you take out a 30-year mortgage for $200,000 with a 7.5% interest rate. This would result in a monthly payment of about $1,400. But where does that 7.5% rate come from? Simply put, it’s calculated by taking the annual interest rate and dividing it into monthly portions. Let’s break it down to better understand how mortgage interest rates are determined.
### How Interest Rates Are Calculated
Mortgage rates are calculated on a monthly basis. To find the monthly interest rate, you take the annual percentage rate (APR) and divide it by 12. In our example, dividing 7.5% by 12 gives you a monthly rate of 0.625%. This percentage represents the portion of your loan balance you’ll pay in interest each month. So, in the first month, with a loan balance of $200,000, the interest payment would be $1,250. On top of that, you also pay off a portion of the loan’s principal amount. Over time, as your loan principal decreases, the interest payment becomes smaller as well.
### How Fixed Payments Work
Lenders use something called an amortization formula to calculate a consistent monthly payment schedule. In our example, the total monthly payment is $1,398.43. This amount is split between $1,250 for the interest and $148.43 towards the principal. By the second month, your remaining loan balance is $199,851.57. Applying the 0.625% monthly rate to this new balance results in an interest payment of $1,249.07, leaving $149.36 to go toward the principal. Even as the portion allocated to interest decreases and the portion going to the principal increases, your monthly payment remains steady at $1,398.43.
### Fixed vs. Adjustable Interest Rates
This example demonstrates how fixed-rate mortgages work. With fixed rates, the interest stays the same throughout the loan term. However, there are also adjustable-rate mortgages (ARMs), where the interest rate changes over time based on market conditions. While the calculated amount for interest may rise or fall, lenders adjust the payments to maintain a consistent monthly premium based on current rates.
### Interest Rate vs. APR
When shopping for a mortgage, you’ll typically see two rates listed. First, there’s the “interest rate,” which we’ve used in our calculations. Then there’s the annual percentage rate (APR), which includes additional loan costs like application or origination fees. By law, lenders must disclose the APR, as it provides a clearer idea of the total cost of your loan.
### Putting It All Together
Understanding how interest rates are calculated helps when estimating the overall cost of a mortgage. This knowledge lets you anticipate your monthly payments and evaluate what you can afford. Don’t forget that mortgage lenders are a valuable resource for explaining your options. They can provide clarity about different rates and terms so you can make an informed decision that fits your financial situation.
