The interest rate is the annual rate charged by lenders for the loans borrowers take up.
Although it is usually expressed as a percentage, sometimes they can use the unit of point as well.
For example 1 point will mean 1%.
When this term is used in this manner, it should not be confused with the loan points that refer to fees.
For fixed rate mortgages, interest rates on a mortgage are clearly specified to a borrower before it is accepted.
This is because fixed rates are are interest rates that lenders have committed to and will not change over the life of the loan.
For adjustable rate mortgages, interest rates on the loan will consist of an index rate plus a margin.
When added together, the interest rate on the loan can be determined. This rate is also referred to as the fully indexed rate.
Calculating interest due from interest rate
Before calculating interest due from the given interest rate, a borrower needs to determine the accrual period.
The following are the number of periods each year depending on a loan’s accrual period.
- Annually will have 1 period
- Bi-annually will have 2 periods
- Quarterly will have 4 periods
- Monthly will have 12 periods
- Bi-monthly will have 24 periods
- Bi-weekly will have 26 periods
- Weekly will have 52 periods
- Daily will have 365 periods
There is no standardization of periods for lenders to adhere to.
But the most common one is a monthly period consisting of 12 periods in a year.
If a $200,000 mortgage is on a monthly period and has an interest rate of 6%, then the monthly interest will be:
0.06/12 = 0.005
The monthly interest due on the home loan will then be:
$200,000 x 0.005 = $1,000
Even though the above is the most basic calculation method, borrowers must note that lenders might have different ways of how interest due is calculated.
When in doubt, borrowers should ask the lender directly to have a better understanding of how the dynamics of their loans work.
The price on a mortgage does not consist of just interest rate
As borrowers often put interest rates as the focal point when comparing and choosing between housing loans, what often slip their mind is that the cost of a mortgage makes up a host of closing cost items as well.
The most prominent expense after interest rate is points.
Points play such a crucial role from the perspective of lenders that borrower can often trade points for interest rates. And vice-versa.
For example, a borrower can offer to pay more points in exchange for lower rates. Or volunteer higher interest rates for lesser points.
Since loan points is a costs of credit and calculated as a percentage of the loan amount, it is often more worth while for smaller mortgages to take on lesser points.
Especially when the home buyer knows that the house will be sold in the near future.
However, the borrower owes it to himself to work out the numbers to decide accordingly to his findings.
Why two borrowers buying the same type of property have different interest rates?
There is no good way to explain this other than to acknowledge and accept that lenders use sets of criteria to determine which borrowers deserves the best rates.
Some of the reasons that might result in one borrower having a higher interest rate than another include:
If you feel strongly that you have been wrongly penalized, do confront the lender or mortgage broker for clarity.
Interest rate vs total interest
A method that borrowers often use to determine how expensive a mortgage is, is to focus on the total interest which they would pay instead of the interest rates itself.
This is a grave mistake that people who make it pay for it for years to come.
The fundamental feature of loan’s affordability is it’s interest rate.
Total interest payments can be affected by the loan amount and the term of the loan. Any one of these 2 factors can grossly inflate or deflate interest charges and cause a borrower to misinterpret how cheap or expensive the loan really is.
A good example is borrowers who take up bi-weeklies with high interest rates. But because of how the loan is structured, borrowers are sold the illusion that they are paying less interest.
The truth is that lower payments are caused by a shorter term. This can be true even when the interest rate is slightly higher.
Quoted interest vs actual interest
Borrowers who are able to grab the attractive low mortgage rates they see in advertisements are a minority.
The majority of borrower actually never get even a whiff of those interest rates.
This is because figures used in promotional material often use generic prices that take into account the most favorable of assumptions of a borrower’s profile.
Some of the reason why you might not get the low quoted rates could be:
- You are not going full documentation
- The house in question will not be your primary residence
- Your credit record is blotted with adverse records
If the quoted rate is based on a variety of assumptions, a borrower who does not meet those assumptions will inevitably be offered a rate higher than what was quoted.
Interest rate or APR?
As annual percentage rate is often seen in marketing collateral, borrowers sometimes put more weight on APR than the actual interest rate.
What borrowers need to know is that the calculation of APR accounts for all charges and costs of the loan.
More about APR has been discussed here.
So what should you choose?
If you have already decide to go the stable route of fixed rates, a good way to compare between FRMs is to add up all fees (while excluding some) and convert them to a percentage of the loan amount.
Then get lenders to finance all costs and quote the interest rate for such a structured deal.
This will enable a borrower to lay out all loans on the table and observe which has the lowest rate.
When choosing between ARMs, borrowers need to take into account the index used and the margin.
Interbank rates for example are very popular as they have been depressed for the last decade or so.
Don’t be misled by a low margin… as the index might kill you. By the same line of though don’t just focus on the index rate.
If you have little choice but to take on an expensive loan, don’t rule out the prospect of refinancing in future.
In fact, refinancing should be in your strategy.
In view of this, a mortgage with low or no prepayment penalties can play into your objectives nicely.