Mortgage lenders often display their interest rates conspicuously, yet seldom do they elaborate on how these rates function. Let’s say you have a 30-year mortgage worth $200,000 at a 7.5 percent interest rate, resulting in an estimated monthly payment of around $1,400. But where does this 7.5 percent interest rate come from? Simply put, it’s the monthly interest derived from dividing the annual rate. Thus, we’ll delve into aspects related to mortgage interest rates to better understand their workings.
Explaining Interest Rate Calculation:
Mortgage interest rates are computed monthly. To obtain the monthly rate, the annual rate is divided by 12 months. Using our example, 7.5 divided by 12 equals a monthly rate of 0.625 percent, which represents the percentage of your principal balance that you must pay each month. For the first month, on a principal balance of $200,000, the ensuing payment, considering the 0.625% rate, amounts to $1,250. On top of this, you pay a portion towards the principal. With each subsequent month, as the principal shrinks, the interest payment does too.
Appreciating the Interest Rate Formula:
Banks deploy a ‘amortization formula’, which creates a fixed payment schedule. In our case, the total amount payable monthly is $1,398.43, divided into $1,250 as interest and $148.43 as principal. By month two, the principal drops to $199,851.57; it’s multiplied by the 0.625 percent, amassing an interest charge of $1,249.07. A principal of $149.36 is then paid, keeping the total payment consistent at $1,398.43 each month. Gradually, the interest decreases and the principal repayment increases, maintaining the uniformity of the monthly premium.
Understanding the Different types of Interest Rates:
This computation provides insights into how fixed-rate mortgages operate. Likewise, an adjustable-rate mortgage (ARM) functions similarly, but the interest rates fluctuate with market changes. Consequently, if an ARM’s monthly interest rates rise or fall, these variations are calculated to ensure a steady monthly premium.
Interest Rate VS APR:
Mortgages are typically promoted with two distinct rates: the ‘interest rate’ used in our previous calculations, and the ‘annual percentage rate’ or APR, which factors in additional loan costs such as origination and application fees. By law, these costs must be included in the APR provided by mortgage lenders.
Conclusion:
Understanding different mortgage scenarios can help you grasp the total cost before proceeding with the loan. The provided methodology assists you in estimating your interest and monthly payments based on your principal. Moreover, don’t overlook the support that mortgage lenders can offer in helping you better comprehend your interest rate options. These accessible resources can be invaluable in deciding what is most beneficial for your circumstances.
