How Does Mortgage Interest Work?

Mortgage interest

Purchasing a home with a mortgage is the largest financial transaction most of us will ever make. Typically, a mortgage lender or bank will provide 80% of the home appraised value, and you agree to repay it with a specified amount of interest. It’s essential to understand how a mortgage works and which type is best by comparing lenders, mortgage interest rates, and loan options. 

Calculations of Mortgage Payments

You pay part of the loan amount (principal) plus interest every month for most mortgages. Your moneylender will use an amortization formula to develop a payment plan which divides each payment into principal and interest. 

When you make payments according to the loan amortization schedule: the loan will be entirely repaid after a specified period (for example, 30 years). Each payment will be an equal dollar amount if the mortgage is a fixed-rate loan. With adjustable-rate loan mortgages, the payment will change periodically as the loan interest rate changes.

The term of your loan also determines the amount you pay each month, e.g., the longer the loan term, the lower your monthly installments will be. 

The tradeoff is that the longer you take to settle your mortgage, the higher the purchase cost for your property—as you’ll be paying interests for a longer duration. 

Fixed-Rate vs. Adjustable-Rate Mortgages

Banks and lenders generally offer two main types of loans.

  1. Fixed interest rate: the interest rate does not change.
  2. Adjustable interest rate: interest rate changes under certain conditions (also called variable interest rate or hybrid loan). 

Fixed-Rate Mortgages

The interest rate and the monthly installments of this type of mortgage remain fixed throughout the loan term. Mortgages often have a payment life span of 30 years; however, shorter terms, of 10, 15, or 20 years, are also common. Shorter loans have large monthly installments but lower interest costs. 

Example: 

A 30-year fixed-rate mortgage with a term of 200,000 USD (360 payments per month) has an annual interest rate of 4.5% and a monthly payment of approximately USD 1,013. (This figure could not include the real estate tax, personal mortgage insurance, and homeowner insurance because these are optional). The annual interest rate of 4.5% corresponds to a monthly interest rate of 0.375% (4.5% divided by 12). So, you will pay an interest of 0.375% on your outstanding balance.

The bank charges $750 as loan interest and $263 as principal when you pay $1,013 for the first time. Repayment in the second month will accrue little interest, and a considerable amount will be added to the principal balance. By payment 359, the entire month’s payment is credited to the principal loan of the borrower.

Adjustable-Rate Mortgage (ARM)

The monthly payment may vary during the loan term since the interest rate of an adjustable-rate mortgage is not fixed. Lenders usually offer lower interest rates for the first few years of an ARM, sometimes called a teaser rate, and then the rates are adjusted in line with customer requirements. The initial interest rate on ARM’s is typically lower than fixed-rate mortgages. Therefore, ARMs can be appealing if you are planning to stay in your apartment for few years.

Example:

A $200,000 five-to-one-year adjustable-rate mortgage for three decades (360 monthly repayments) may start with a yearly interest rate of 4% for five years. Thereafter, the rate is allowed to change by as high as 0.25% each year. The payment amount for months 1 through 60 will be $955 per month. If there is a subsequent increase of 0.25%, the payment for the 61-72 months will be $980, and the payment for the 73-84 months will be $1005. (Again, these figures don’t include taxes and insurances).

Interest-Only Loans

Interest-only mortgages are a rarer third option, typically for wealthy home buyers or people with irregular incomes. As the name suggests, this type of mortgage loan provides the option to pay only the interest for the first few years, thereby reducing the monthly repayment expenses. It might be a reasonable choice if you plan to own a home in a relatively short time and sell it before the start of a larger monthly payment. However, you won’t develop any equity in your property, and if your property declines in worth, you could wind up owing more than it is worth.

Don’t forget about taxes, insurance, and other expenses.

Here are other things you need to consider when buying a home. It may significantly increase your monthly mortgage payment, even if your interest rate is high. For example, your lender may require you to pay property taxes and insurance as part of the mortgage payment. Your lender will list the additional fees as part of your mortgage and recalculate them periodically. The money will be transferred to an escrow account and your lender will pay the bill. More so, these expenses can increase over time (as not fixed). Your lender will list the additional fees as part of your mortgage and recalculate them periodically.

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