How Interest Rates Work?

Nations Choice Mortgage shows their interest rates prominently, but who knows how these rates actually work?

If you have a \$200,000 mortgage for 30 years at, say, 7.5 percent interest, your monthly payment would be about \$1,400.  The question is: why the rate of interest at 7.5 percent? The suitable answer is: the annual rate is divided into the monthly interest rate and this monthly interest rate is applied to the monthly balance.

Now, let’s discuss the related factors with mortgage interest rates to find out how the rate of interest works.

Interest Rate Calculation

The interest rate for mortgages is calculated monthly.  In order to achieve the monthly rate, you must divide the annual rate by 12 months. In the case of this mortgage, 7.5 divided by 12 comes out to a monthly rate of 0.625 percent.  So, every month you have to pay interest calculated at 0.625 percent of your principal balance.

For the first month, consider your principal balance \$200,000. Applying a monthly rate of 0.625 %, your first monthly payment toward interest would be \$1,250. Along with this interest amount, you also need to pay off a little of the principal too, for the first month.  For the next month the interest becomes a bit less as the principal has become smaller, and so on and so forth.

Understanding the Interest Rate Formula

Nations Choice Mortgage and all reputable mortgage lenders use a formula that is known as ‘amortization formula’. This formula is used to generate a schedule of payments so the total payable amount for every month becomes the same.  For the above loan amount, the monthly payable amount will be \$1,398.43. This amount consists of two parts, they are: \$1,250 as interest and \$148.43 as principal. In the second month, the principal is now down to \$199,851.57.  Multiply that by the monthly rate of 0.625 percent, and you get an interest charge of \$1,249.07. You’ll also pay \$149.36 in principal, for a total payment of \$1,398.43. Clearly, the amount you pay each month stays the same as the first month and continues each month thereafter.  Each month the interest amount paid becomes smaller and the principal amount paid becomes larger to attain a consistent monthly premium.

Most Common Types of Interest Rates

These calculations show how fixed rate mortgages work.  An adjustable rate mortgage or ARM works in a similar way.  The main difference between a fixed rate mortgage and an ARM is the ARM interest rate will adjust with the market. When an ARM’s interest rate goes up or down each month, the rate calculates accordingly to keep a fixed monthly premium that you pay for each month.

Interest Rate VS APR

There are two different rates on which mortgages are advertised. The first one is called ‘interest rate’ which is used to calculate the monthly payable amount as described above. The other rate is called ‘annual percentage rate’ or APR.  There are some costs in addition to the interest that you have to pay for the each and every loan. These are: origination fees, application fees, etc.  By law, APR must be applied to the loan by the mortgage lender.

Conclusion

Nations Choice Mortgage wants you to be aware of the different scenarios that might help you better understand your mortgage.  Through the process shown above you can calculate your interest and monthly payable amount for each month based on your principal balance.  If you have further questions, Nations Choice Mortgage can help you better understand your interest rate options.  There are several mortgage resources available that can be very helpful in explaining what is best for your situation.

Set your Twitter account name in your settings to use the TwitterBar Section.