The Basics about Interest and Interest Rates
Mortgage News from Quicken Loans
What are interest rates and why are they so important when you get a mortgage? To understand interest and interest rates, it's important to understand a little about mortgages and mortgage payments.
Put simply, a mortgage is a loan that you get from a bank or a lender that is secured by a property, your home. You make payments monthly to the bank or lender in order to repay that loan. A basic monthly mortgage payment is made up of two parts: principal and interest. However, the monthly payment can also include property taxes and home insurance.
The principal is the amount of money you borrowed from the lender. So, for example, you want to buy a house that costs $100,000. Let's say you've saved up $10,000 for a down payment. Now you need $90,000 more in order to purchase the house. You go to your lender and get a mortgage for $90,000 which goes to the seller of the home. But in order to get that money, it will cost you.
Mortgage lenders charge you interest on top of the money you borrow and to calculate how much interest you have to pay, they have to use the interest rate. The amount of interest you owe the lender depends on the interest rate and the loan amount. Generally, the lower the interest rate, the less interest you owe; same with the loan amount and loan term (how long it takes to pay off the loan).
Using the numbers from our previous example, let's say the interest rate is 6.25 percent. If you took a 30-year fixed-rate mortgage, the interest portion of your payment (for the first month) would equal $468.75 ($90,000 x 6.25% divided by 12 months in a year).
The principal plus interest payment (again, for the first month) would equal $554.15. You're probably saying to yourself, "That's a lot of interest I'm paying!" In the beginning, that's true. But remember, as your loan principal decreases over time, so does the amount of interest you pay. So in the beginning half of the 30 years, you pay more interest than principal. In the latter half of that 30 years, you pay more principal than interest.
If you wanted to pay less interest over the long-term, it might be good to get a shorter-term loan, such as a 15-year loan. If your loan is scheduled to be paid off in 15 years, rather than in 30, then you pay less interest over the life of the loan because the loan term is shorter. However, your monthly payments will be more expensive because you are paying more principal to get it paid off in that shorter time period. Again, using the same loan example: your interest rate is 6.25% on a loan amount of $90,000. You'd still be paying the same amount of interest because the rate is the same for the same amount of money. But because you have to pay it off in less time, your monthly principal and interest payment would equal $771.68.
That's not to say that everyone should get a shorter-term loan. That depends on you and your particular circumstances. Not everyone wants to or can afford to pay more per month to pay off their loan faster. And there are short-term loans, such as adjustable rate mortgages (ARMs) that do exactly as the name suggests--the rate adjusts up or down depending on the market. There are good reasons to get an adjustable rate mortgage, but again, that depends on your situation. Always consult an experienced mortgage banker to find out what is best for you.
Interest rates play a big part in getting a mortgage and while it's important to shop around, don't make it your entire focus. Think also about which lender gives you the best service and attention and whether they are looking out for your needs or their own.
This article is reprinted by permission from Quicken Loans © 2006 Quicken Loans Inc. All rights reserved.
Find more mortgage related news! View all our mortgage news.
