Mortgage Interest Rate Fundamentals
4 October 2001, Revised November 11, 2004, November 24, 2006
Some of the questions about mortgage interest rates I get from readers are surprisingly basic. I have to remind myself that one can graduate from college in the US, and even get a PhD, without ever hearing about interest rates in the classroom. Most people pick up what they know from experience, which is often an unreliable teacher.
Here are some of the questions, starting with the most basic.
An interest rate is the price of money, and a mortgage interest rate is the price of money loaned against the security of a specific property. The interest rate is used to calculate the interest payment the borrower owes the lender.
The rates quoted by lenders are annual rates. On most home mortgages, the interest payment is calculated monthly. Hence, the rate is divided by 12 before calculating the payment.
Take a 6% rate, for example, and assume a $100,000 loan. In decimals, 6% is .06, and when divided by 12 it is .005. Multiply .005 times $100,000 and you get $500 as the monthly interest payment.
Suppose the borrower pays $600 this month. Then $500 of it covers the interest and $100 is used to reduce the balance. One month later, when another payment is due, the balance is $99,900, and the interest is $499.50. The interest rate stays the same, but the interest payment is lower because the balance is lower.
No, the interest rate is more important in the sense that the lower the interest rate, the better off the borrower is. You can’t say that about interest payments, which depend not only on the rate but also on the loan amount and the term. Reduce the loan amount and/or shorten the term and interest payments will fall. Whether either is in your interest depends on the circumstances. Reduce the loan amount and you need to come up with more cash for the down payment. Shorten the term and you have to make a larger monthly payment.
Some borrowers are bamboozled by this argument and pay a higher interest rate or fees for a biweekly mortgage that cuts their interest payments. But the lower interest payments on a biweekly are due to a shortening of the term, which results from making an extra monthly payment every year.
Borrowers can reduce the term on their own at no cost, either by taking a shorter term at the beginning, or by systematically making extra principal payments.
The “fixed-rate mortgage” or FRM has a fixed payment as well as a fixed rate. See Fixed-Rate Mortgages. However, some FRMs have options such as temporary buydown or “interest-only” which result in lower payments in the early years. See What Is a Temporary Buydown? and What Is an Interest-Only Mortgage? And there are graduated payment mortgages which have fixed rates but rising payments over the first 3 to 10 years. See What Is a Graduated Payment Mortgage?
Probably not. The quoted rates are based on numerous assumptions, such as that your credit is good, you have enough income to qualify, you can document your income and assets, you will occupy the house as your primary residence, and on and on. If you don’t meet all the assumptions, your rate will be higher. See What Market Niche Are You In?
In addition, the quoted rates apply today. Rates are reset every day, so tomorrow they may be different. What matters are the rates quoted on the day you lock the terms of the loan. See Can I Avoid Mortgage Prices That Have Lapsed?
Furthermore, not all rate quotes are believable. Some loan providers deliberately quote below the market to get borrowers in the door. Once inside, they are fair game for a variety of stratagems for raising the rate. See Can I Rely on Mortgage Price Quotes?
Some of the questions about mortgage interest rates I get from readers are surprisingly basic. I have to remind myself that one can graduate from college in the US, and even get a PhD, without ever hearing about interest rates in the classroom. Most people pick up what they know from experience, which is often an unreliable teacher.
Here are some of the questions, starting with the most basic.
What Are Mortgage Interest Rates?
An interest rate is the price of money, and a mortgage interest rate is the price of money loaned against the security of a specific property. The interest rate is used to calculate the interest payment the borrower owes the lender.
The rates quoted by lenders are annual rates. On most home mortgages, the interest payment is calculated monthly. Hence, the rate is divided by 12 before calculating the payment.
Take a 6% rate, for example, and assume a $100,000 loan. In decimals, 6% is .06, and when divided by 12 it is .005. Multiply .005 times $100,000 and you get $500 as the monthly interest payment.
Suppose the borrower pays $600 this month. Then $500 of it covers the interest and $100 is used to reduce the balance. One month later, when another payment is due, the balance is $99,900, and the interest is $499.50. The interest rate stays the same, but the interest payment is lower because the balance is lower.
Is the Total Amount of Interest I Pay More Important Than the Interest Rate?
No, the interest rate is more important in the sense that the lower the interest rate, the better off the borrower is. You can’t say that about interest payments, which depend not only on the rate but also on the loan amount and the term. Reduce the loan amount and/or shorten the term and interest payments will fall. Whether either is in your interest depends on the circumstances. Reduce the loan amount and you need to come up with more cash for the down payment. Shorten the term and you have to make a larger monthly payment.
Some borrowers are bamboozled by this argument and pay a higher interest rate or fees for a biweekly mortgage that cuts their interest payments. But the lower interest payments on a biweekly are due to a shortening of the term, which results from making an extra monthly payment every year.
Borrowers can reduce the term on their own at no cost, either by taking a shorter term at the beginning, or by systematically making extra principal payments.
Does a Fixed Mortgage Rate Always Mean a Fixed Monthly Payment?
The “fixed-rate mortgage” or FRM has a fixed payment as well as a fixed rate. See Fixed-Rate Mortgages. However, some FRMs have options such as temporary buydown or “interest-only” which result in lower payments in the early years. See What Is a Temporary Buydown? and What Is an Interest-Only Mortgage? And there are graduated payment mortgages which have fixed rates but rising payments over the first 3 to 10 years. See What Is a Graduated Payment Mortgage?
Can I Borrow at the Rates Quoted in the Media?
Probably not. The quoted rates are based on numerous assumptions, such as that your credit is good, you have enough income to qualify, you can document your income and assets, you will occupy the house as your primary residence, and on and on. If you don’t meet all the assumptions, your rate will be higher. See What Market Niche Are You In?
In addition, the quoted rates apply today. Rates are reset every day, so tomorrow they may be different. What matters are the rates quoted on the day you lock the terms of the loan. See Can I Avoid Mortgage Prices That Have Lapsed?
Furthermore, not all rate quotes are believable. Some loan providers deliberately quote below the market to get borrowers in the door. Once inside, they are fair game for a variety of stratagems for raising the rate. See Can I Rely on Mortgage Price Quotes?