Home Mortgage Essentials: Understanding Interest Rates

The Basics

In understanding interest rates, you should know a few things about the basic principles of money lending and credit. The idea of credit itself goes back to thousands of years B.C. to the ancient Sumerians, who used a combination of grain and metal coins to issue credit and make payments.

Interest Rates and Religion

Although “interest” is frowned upon in some religions that originated soon after that time, almost all modern societies have interest in some form, and nowhere is it as complex—and potentially crippling if it’s not understood—as the home loan industry.

How Interest Really Works

When you pay interest you are paying a fee to use someone else’s money to buy your home. Although you have only one payment to make, it has two parts—“principal,” which is the amount of the original money borrowed that you are paying off, and “interest,” the fee you pay for the right to use the money for a predetermined time. The “interest rate” is the percentage of that original loan amount that you pay over a given period of time.

Types of Interest

There are different kinds of interest. “Simple interest” is a total of the interest over a period of time divided by the original principal. “Compound interest” is a yearly calculation, and although more difficult to understand, solves some problems inherent in simple interest calculations. This interest is given per year, so that when you are told the interest rate is 10% on $100, you will be paying $110 by the end of the loan.

Calculating Interest

A mortgage rate is calculated yearly and the interest is usually figured monthly, so the lender will divide the rate by 12 for each payment. This means that if you have a rate of 12% (mathematically speaking, .12) your monthly rate is .01. To find your monthly payment, multiply your loan amount by .01.

Reducing Your Loan Amount

When you make your payment, however, you reduce your loan amount. This means that your next month’s payment of principal and interest will have a different ratio between the two numbers, while the payment will stay the same. Why? Because you no longer owe the original amount of the loan.

For instance, if your loan amount is $200,000 and your interest rate the aforementioned 12%, your first interest payment is $2,000. If you make a $3,000 payment altogether, $1,000 of this goes toward paying off the loan amount, or principal. So your next interest payment will be on $199,000, and will amount to $1,990. When you make your $3,000 payment, then, $1,010 will go towards the principal. It doesn’t sound like much of a difference, but over time you will make a large dent in the amount you owe, and your last payment will have much less interest than principal.