Mortgage lenders often showcase their interest rates prominently, but they rarely explain how these rates work. For instance, if you have a 30-year mortgage for $200,000 with a 7.5 percent interest rate, your estimated monthly payment would be about $1,400. But where does the 7.5 percent interest rate come from? It’s actually the annual rate divided to a monthly figure. Let’s break down how mortgage interest rates function.
### Explaining Interest Rate Calculation
Mortgage interest rates are calculated monthly by dividing the annual rate by 12. For example, with a 7.5 percent annual rate, you divide that by 12 to get a monthly rate of 0.625 percent. This percentage is applied to your remaining principal. In the first month, if your principal is $200,000, you’d pay $1,250 in interest (200,000 x 0.625%). You also pay a portion of the principal amount. As the months go by and the principal decreases, the interest amount you pay also goes down.
### Understanding the Interest Rate Formula
Banks use something called an amortization formula to set a fixed payment schedule. In our example, the total monthly payment would be $1,398.43. This includes $1,250 for interest and $148.43 for the principal. By the second month, your principal decreases slightly to $199,851.57, which means the interest for that month will be $1,249.07. At the same time, the principal portion of the payment is slightly higher, $149.36, but the total payment remains $1,398.43. Over time, the amount you pay in interest decreases while the amount you pay towards the principal increases, keeping your monthly payment the same.
### Understanding the Different Types of Interest Rates
This method explains how fixed-rate mortgages work. Adjustable-rate mortgages (ARMs) are similar but have interest rates that change with the market. As the rates go up or down, the monthly interest changes too, but the goal is to keep your monthly payment consistent.
### Interest Rate vs. APR
Mortgages are usually advertised with two rates: the interest rate and the annual percentage rate (APR). The interest rate is what we used in our calculations, while the APR includes additional costs like origination and application fees. Mortgage lenders are legally required to show you the APR so you’re aware of these extra costs.
### Conclusion
Understanding how different mortgage scenarios work can help you gauge the total cost before you take out a loan. This approach lets you estimate your interest and monthly payments based on your principal. Additionally, mortgage lenders can help you understand your interest rate options better. These resources can be invaluable in helping you decide which mortgage is the best fit for you.