Mortgage lenders often show interest rates openly but rarely explain how they actually work. For example, if you have a 30-year mortgage of $200,000 with a 7.5 percent interest rate, your monthly payment is roughly $1,400. But how is this 7.5 percent interest rate determined? It’s based on the monthly interest derived from dividing the annual rate.
Breaking Down Interest Rate Calculation:
Interest rates for mortgages are calculated monthly. You get the monthly rate by dividing the annual rate by 12. In our example, dividing 7.5 by 12 gives you a monthly rate of 0.625 percent. This percentage of your principal balance is what you pay each month. For the first month, on a $200,000 principal, the payment at a 0.625 percent rate would be $1,250. Additionally, you pay a portion towards the principal. As the principal decreases each month, the interest payment decreases too.
Understanding the Interest Rate Formula:
Banks use an ‘amortization formula’ to set a fixed payment schedule. For instance, your total monthly payment is $1,398.43, broken down into $1,250 for interest and $148.43 towards the principal. By the second month, the principal reduces to $199,851.57, and multiplied by 0.625 percent, the interest charge comes to $1,249.07. You then pay $149.36 towards the principal, keeping the total monthly payment steady at $1,398.43. Over time, the interest portion decreases and the principal portion increases, while the total monthly payment remains the same.
Types of Interest Rates:
This method shows how fixed-rate mortgages work. Adjustable-rate mortgages (ARMs) work similarly but the interest rates change with market conditions. If an ARM’s monthly interest rate changes, these fluctuations are calculated to keep the monthly payment consistent.
Interest Rate vs. APR:
Mortgages typically have two rates listed: the ‘interest rate’ we used in our calculations, and the ‘annual percentage rate’ or APR, which includes additional loan costs like origination and application fees. By law, these costs must be included in the APR that mortgage lenders provide.
Conclusion:
Grasping different mortgage scenarios can help you understand the full cost before committing to a loan. This method allows you to estimate your interest and monthly payments based on your principal. Additionally, don’t forget that mortgage lenders are there to help you understand your interest rate options better. These resources can be very helpful in deciding what works best for you.