A mortgage rate is the annual percentage in interest (APR) a lender charges a mortgage holder on their initial loan or "principal." With a fixed rate mortgage, this rate will stay the same over the entire term of the loan. With an adjustable rate mortgage (ARM), this percentage changes in regular intervals over the term of the loan, also adjusting the interest-to-principal ratio of the monthly payments accordingly.
Fixed rate mortgages have slightly higher interest rates than comparable ARMs because they offer more security against severe market fluctuations. This helpful overview explains how lenders determine mortgage rates.
How Interest Rates Affect the Consumer
Presently, the Federal Reserve is trying to stimulate the economy by keeping interest rates low, which consequently means that mortgage companies are seeing fewer and fewer pure ARMs. Convertible options however, are still popular because they allow homeowners to take on a low initial rate and lock in on it if it fluctuates lower, or rises quickly.
Interest rates are measured in "points" which is another term for percentage points.
Calculating Monthly Payments Based on Interest Rates
While an online calculator is keystrokes away and will break down and display a monthly payment schedule or "amortization calendar" in the blink of an eye, it is wise for consumers to be educated and understand exactly how they’re calculated.
In the United States, the monthly payment for this mortgage is calculated using the following equation, where
k = Monthly interest in decimal form = APR / (12 months * 100)
n = The number of months over which payments will be made (360 for a 30-year loan)
p = Principal
M = monthly payment:
M = (p * k) / [1 – (1 + k)-n]
(p * k) is how much of that monthly payment goes to interest for the first month. M – (p * k) is how much of M goes toward the principal. Because monthly installments do not change, subtract that amount from the original principal call that q, and multiply (q * k) to find how much interest the second month’s payment will be comprised of.
Consider a 30-year fixed rate mortgage of $125,000, at an interest rate of 5% (exclude PMI and property tax).
p = $125,000; k = 0.00417; and n = 360 months. This yields a monthly payment (M) of $670.79, $521.25 of which goes toward interest, leaving $149.54 to pay down the principal amount. Subtract $149.54 from $125,000 to find the new principal amount. Go through the same process using this amount (q) in place of p to find each subsequent month.
For an adjustable interest rate, recalculate k when a new interval starts.
By comparison, a bi-weekly mortgage deducts an additional monthly payment (M) directly from the principal at the beginning of every twelve month cycle, such that, with the above mortgage, the borrower will subtract an additional $671 from the $123,155 left on their principal ($122,484) and calculate month 13 of the amortization chart accordingly with the new principal amount.
What this equation fails to explain however, is how lenders arrive at these interest rates.
Factors that Determine Interest Rates
The main factor that determines the interest rate of a mortgage is the present state of the economy and, in particular, of the housing market. Because our economy works on supply and demand, less supply means more demand, which means more competition for the same house — which means that lenders can charge higher, more competitive interest rates.
Similarly, in a housing market where there are more homes than buyers, as is the present occasion, interest rates are lowered in order to encourage consumers to buy homes.
Using the national average as a ballpark, lenders then give or deduct whole or partial points based on the borrower’s credit score, income, length of time at a job, percentage financing, the length and amount of the loan, which options are included in the loan, and a number of other factors.
Some lenders will allow borrowers to buy down their interest rates by paying a certain number of points at the time of closing.
To improve their interest rates, potential homebuyers should do their best to improve their credit before applying for a mortgage. This means bringing all debts current and removing any blips from their credit report.
While doing so, it is a good idea to accumulate money in a bank account. Not only does this give a buyer more money to use as a down payment, but also shows lenders that the buyer is able to hold onto money. Lenders see such a consumer as less of a risk and are thus willing to offer them lower interest rates.
Anyone in the market for a mortgage should always shop around for the lowest interest rate they can find that will yield an affordable monthly payment.