What You Need to Know About Interest Rates
Undoubtedly you’ve heard homeowners boasting about great interest rates on the mortgage, but what exactly is interest? Essentially, interest in an additional fee you pay your lender for loaning you money to buy your home. You can’t escape paying interest unless you have enough money laying around to make an all-cash offer.
Since this is not realistic for the majority of us, it’s important to understand how home loans and interest rates works.
How Interest Rates on Home Loans Work
When you get a mortgage, your interest payment is calculated as a percentage of the total loan amount. If you were to get a 30-year $200,00 loan with a 4% interest rate, you would end up paying back the $200,000 loan amount in addition to $143,739 in interest.
In this instance, you would have monthly mortgage payments of about $955, and part of that monthly payment goes toward paying back your principal. The rest of the payment goes towards interest. The exact proportion of principal/interest varies monthly – early in repayment homeowners often pay more interest and less principal – but this proportion changes as the loan matures.
As an example, using the numbers above, you would pay $288 towards your principal and $666 to interest. By the time you reach your last payment 30 years down the road, you would pay $951 towards principal and only $3 to interest.
What does the payment schedule mean for you as a homeowner? It means that it will take time to build equity in your home, because you are paying mainly interest during the early years of your loan. The bonus to all of this? Interest paid on your home loan is tax deductible, so you will receive a sizable tax break early on that will dwindle as the equity in your home grows.
Interest Rate Fluctuation
Interest rates fluctuate based on several factors.
Author of “The Mortgage Encyclopedia,” Jack Guttentag says, “during a period of slack economic activity, [the Federal Reserve] will provide more funding and interest rates will go down.” However, “when the economy heats up and there’s fear of inflation, [the Fed] will restrict funding and interest rates will go up.”
If these financial shifts affect your monthly mortgage payments, you may experience significant stress, but you can help protect yourself by choosing a fixed-rate mortgage. A fixed-rate mortgage is pretty much what it sounds like – the interest rate you get when you apply will remain the same during the entire course of the loan. If you’re okay with handling the market’s ups and downs, you can choose an adjustable-rate mortgage.
How You Can Get a Low-Interest Rate Loan
Not everyone who applies for a mortgage gets the same interest rate; the interest rate that you are offered depends upon a large variety of factors. The largest variable is you – credit score determines the interest rate that you are offered. If you have good credit, you will get a lower interest rate while a poor credit score will result in higher interest rates. Before applying for a mortgage loan, it’s important to know your credit score, fix it if needed and maintain it to keep your score high.
Another variable that impacts interest rates is the type of loan you apply for. For instance, 15-year loans tend to have lower interest rates than 30-year loans and adjustable-rate mortgages (ARMs) have lower interest rates than fixed-rate mortgages – at least to begin with.
So what does all of this mean? Paying interest is a reality if you want to own a home, but the amount of interest you pay will vary widely upon multiple factors. Before you apply for a loan, it’s important that you get as much information as possible and that you understand the basics of what you are getting involved with.