How Does Mortgage Interest Work?

Certified Mortgage Advisor
NMLS 1701021
Published 
April 2, 2020

Mortgage interest and how it works

Today, we're talking about how does mortgage interest works. So let's go ahead and dive into how the ins and outs of mortgage interest work because it can feel super overwhelming to think we're going to take on a ton of debt and it's going to be a ton of interest. So the more that we understand it, the more money we can save and the more comfortable and competent we feel about moving forward with a home loan.

What is interest?

First of all, Interest, what does it mean? It's basically just the annual cost to borrow money. An interest rate is just the annual cost to borrow money. That's it. So if you have a hundred thousand dollars as a loan at a 4% rate, you're going to get charged 4% each year in interest. So that would equal $4,000 per year in interest. It's really that simple, not as difficult as it is.

APR vs. Interest Rate

Now, there are two things that you want to look at. One is the industry and the other is the APR. So the interest rate is what we're more familiar with. It's this formula up here, right? It's just the annual cost of our money. The APR tells us your interest rate plus any fees that are required to close on a loan.

So for instance, when you're getting a mortgage, it's your interest rate plus things like any underwriting fees, administration fees, title fees, mortgage insurance, those are all included in the APR. The costs that are required to get alone are included in the APR. So a way of thinking about the interest rate is the rate at which you're getting charged interest and the APR is like the total cost involved with that loan.

So if you're comparing two different lenders, one lender might have a lower interest rate, but the other one has a lower APR. And what that would tell us is that lender has lower fees compared to the other lender.

Fixed vs. ARM

Also with interest rates, they're either going to be fixed or adjustable. So most people want to get a fixed loan and a fixed loan means our interest rate is never going to change. It's never going to go up or down. It's going to stay consistent throughout the entire duration of that loan, whether it's 30 years at 20 years, 15 years, 10 years, it's always going to be the same.

ARM

An Adjustable Rate Mortgage or ARM is going to fluctuate depending on a couple of different terms of how the loan is set up. Sometimes an arm is fixed for maybe five years and then it adjusts every single year. So your interest rate for the first year might be 4% but then the next year, it's 5% the next year, it's 3.5% the next year it's, it can change each year. So it's something to be careful of.

Normally a fixed loan is going to be best for you unless you really know what you're doing with an ARM that can belittle dangerous sometimes. So watch out for that.

Shows the flow of money but not the total cost

So again, this shows us the flow of money. An interest rate shows us how money flows, but it doesn't actually show us the overall cost. This is where people really mess up when they shop for a home loan is they're so trained to just focus on the interest rate.

Lower interest rate doesn't means it's a good loan

But the problem is just because you have a lower interest rate, doesn't mean it's a better loan. You need to be looking at the total cost. The APR helps us understand what that looks like. It's not the full picture in the APR. What you really need is something called a Total Cost Analysis that's something that we do that shows actual cash coming out of somebody's pocket over a period of years, comparing different loans side-by-side. But if you just look at the interest rate, you're going to ignore everything else, like mortgage insurance and the fees and everything that's included in there.

What determines the rate?

So if you call a lender and you say, Hey, what's the rate? First of all, it's probably gonna be very difficult for them to give you an answer. If they give you an answer there, you probably shouldn't work with them because it's a little, not fair to quote an interest rate to somebody who has no idea anything about their situation. And if they qualify for a specific interest rate or not.

Your risk profile, market and the lender

Interest rates are all determined based on three primary things. So it's your risk as a buyer. So how risky are you to lend money to?  Also, it's dependent on the market and it's dependent on the lender and how they set up their business.

Risk Profile

So first with your risk profile, it's all about your credit score. So obviously a higher credit score gets you a better interest rate. What kind of down payment do you have, what kind of loan size do you have?

There are all these factors that make up how risky it is to give you money statistically and lenders are going to change the interest rate depending on if it's riskier to give you money or not. So if you don't have great credit you don't have a great history of borrowing money. So a lender needs to make sure that they get a higher interest rate, then they make more money off of that loan because it's riskier to give that money. Whereas somebody who has really great credit they've shown that they have a really good history of managing debt. So a lender doesn't have to make as much money on it.

The Market

Also, you have the market, so the market is going to change how interest rates are given. This mainly happens in the secondary market where mortgage-backed securities are sold. A lot of your retirement accounts probably have mortgage-backed securities in them. So what ends up happening is lenders give out money to people on the secondary market purchase it, package it into mortgage-backed securities.

Then we, as consumers end up purchasing mortgages, you probably have mortgages in your retirement account or investment portfolios, and you might not even know about it. So the market and the economic health of our country are going to determine interest rates because interest rates 20 years ago used to be anywhere in the eight to 14% range. Now that we're at a different economic position, we're seeing interest rates closer to three to 5%.

The Lender

Then also the lender is going to determine what your interest rate looks like as well. So some lenders just operate on lower margins so they can give better interest rates. Other lenders might only work with loans that have lower credit scores. So they have higher interest rates.

It all just depends on the lender and how their business is set up. Do they have a lot of layers of management or are they a smaller operation, do they have big marketing expenses, or do they have little marketing expenses. It's all going to determine how much money they're making as a lender and how much they charge and an interest rate.

Points and credits

Also, there's a difference between points and credits. So there isn't one interest rate. There isn't just an interest rate given to you and that's it. You have a whole choice of interest rates, and this is how it works.

How interest rates are given

So I'd like to think of it like a, almost like golf. So if you golf and you hit par for the course, it's almost it's like a zero. You didn't hit over, you didn't hit under, you basically just hit zero, which was perfect. It was par for the course. Interest rates are given in the same way.

They're given at a par value. So you as a buyer, depending on how risky you are, you're given a par rate. Then you can choose to buy down the rate so you can pay extra money to lower it, or you can receive money to increase it. So what ends up happening when we talk with a buyer is that we have a par rate.

Example

Note that this is just an example it might not work like this in real life. So let's say in this instance, the par rate is 4% and that costs them $0. The buyer could get a 3.8, seven, 5% rate maybe if they paid let's say $1,000. Then maybe they could go up to a 4.125% rate and they would receive a credit of $1,000. So you can choose on a sliding scale of where you want your interest rate to be and the cost of credit that you're willing to get for it.

So if you need extra money at closing, you could increase your rate and receive a credit. If you wanted to pay down your interest rate and you knew where you were going to be in the property for a long period of time, you could buy it down and lower your interest rate.

How to manually calculate

So now let's talk about how to manually calculate your interest rate. It's super easy. We already did it. But just going back to this example, take whatever your loan amount is, multiply that times the interest rate, and that's going to be how much interest you pay per year.

So on a hundred thousand dollar loan at 4% interest, we're paying $4,000 per year. If I divide that by 12, you're paying $333 a month in interest on that hundred thousand dollar loan. So the way that your payment is structured is that your payment is always going to be fixed for the life of the loan if you're using a fixed alone, as opposed to an adjustable-rate mortgage.

Interest is high then becomes low as you pay

But what ends up changing is the interest. So interest starts out being high in the beginning and then lowers towards the end of your loan. That's because each time you pay into the principal balance of your life there's less to be charged an interest rate. If we go to this example again, let's say that a couple of years down the road, all of a sudden our loan balance is $90,000. It's still at a 4% rate, but now we end up only having to pay instead of $4,000 per year. We only have to pay. $3,600 per year. So each year that continues to decrease our payment stays exactly the same, but the amount that goes towards interest lowers in the amount that goes towards the principal balance increases.

30 year vs. 15 year

So one final example, just to show how interest rates work over a period of time is a classic example of a 30 year versus a 15-year loan. So I calculated an example of a $200,000 loan at 4%. If you did 30, a 30-year loan, you would end up paying $465,480 over 30 years. So you're paying over double the actual value of the home. You're paying twice as much as the home is worth over 30 years.

If you shorten that to a 15-year mortgage, you're paying $328,184 over 15 years. So still you're paying more than you're paying over a hundred percent of that. It's not double, not quite double at that point, but you're paying an additional $128,000 just in case. So the savings of going from a 30 year to a 15-year loan is $137,296.

Big impact when we pay longer

So interest rates have a big impact, the longer that we stretch them out and really, interest rates are all just about how money is flowing. Not the actual cost. So what you want to do is work with a lender who's going to show you the actual cost and compare loans side by side, to see isn't as a lower interest rate, actually better. Because sometimes a lower interest rate can actually be more expensive with its total cost over a period of time. This will give you a good idea of how interest rates work for mortgages.

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