What is the Interest Rate?

Banks Editorial Team · April 25, 2018

What is the Interest Rate and Why is it so Important? Interest rates are the cost of a loan and are generally expressed as a percentage of the principal. Mortgage and home refinancing interest rates are the major cost of a home loan banks and lenders charge borrowers. There are other costs such as loan fee and insurance premium that may be attached to a mortgage. APR is the total cost of the loan including the interest rate, loan fees, and any other additional costs. When comparing rates among lenders, the APR is a more accurate measure than just the interest rate. This is because it reflects the total price you will have to pay for the loan.

How to Calculate Mortgage Interest Rates

Mortgage interest rate is the amount charged by a bank or lender on the money being loaned to the customer when buying or refinancing a home. It’s generally expressed as an annual percentage of the money being loaned (the principal). The interest rate quoted is generally an annual rate. It is divided by 12 and applied to the mortgage loan when calculating monthly mortgage payment. For instance, if the interest rate is 4% on a $100,000 loan, the 4% interest rate will be divided by 12 (4%/12 = 0.0033). If you multiply 0.0033 by $100,000, you get $330 as the monthly mortgage interest due on the loan.

However, there are generally other fees that are factored into what is the interest rate. The upfront loan fee, the mortgage insurance premium for those making a low down payment, and points which recently became tax deductible under the new tax law signed by President Trump in 2017. These extra loan charges are factored into the interest rate and the total rate is called APR.

Most banks and lenders such as Wells Fargo or Bank of America list both their mortgage interest rate and their APR. The APR is normally a little higher than the interest rate. The APR a lender offers is divided by 12 and used to calculate the monthly mortgage interest. The total monthly mortgage payment is the monthly mortgage interest payment plus a portion of the principal.

Monthly Mortgage Payments

Knowing what is the interest rate is will help understand mortgage monthly payments. The total monthly mortgage payment is not just dependent on the APR or interest rate, but also on the term of the loan. For instance, you will have a lower monthly payment for a 40-year loan than a 30-year loan. However, you will also end up paying more because you will be paying interest for a longer period. Factors such as credit score are also important. In general, the better your credit score, the lower the interest you will be able to get if you’re buying or refinancing a home. However, the interest rate and APR offered by banks and lenders varies.

How to Choose a Mortgage Lender

It’s best to compare what is the interest rate and APR offered by various mortgage lenders to find the best deal for you. The interest rate is applied to most of the principal at the beginning of the mortgage payment so most of the initial payments go towards paying off the interest. Towards the end of the mortgage payment, however, most of the payment goes towards paying off the principal.

Most lenders and banks offer two types of loans: fixed rate mortgage and adjustable rate mortgage (ARM). Fixed rate doesn’t change during the term of the loan so you will be paying the exact same amount monthly for the duration of your loan. Fixed rate mortgage generally last for 30 years, but you can also negotiate a lower term such as 25 or 20 years. As explained above, shorter terms will require a larger monthly payment but will have a lower overall cost. On the other hand, an adjustable rate can change under defined conditions that may see the borrower paying less or more depending on how the defined condition change in the future. Most ARMs have a significantly lower interest rate at the beginning of the loan (for instance the first five years) and the rate may adjust frequently after (as much as once per year). However, most lenders offer a cap on how much the interest rate can fluctuate. The defined conditions which can determine the variable interest rate is generally a financial index such as a one-year U.S. Treasury bills or interest rate or announced by the US Federal Reserve.

ARMs are suitable for people who only plan to stay in the home for only a few years, however, it is best to consult your financial adviser to ascertain if ARMs are a good fit. The role interest rates play when buying a home as explained above is not different from the role it plays while refinancing a home. However, refinancing a home offers an opportunity to gain a lower interest rate and a lower overall monthly payment. However, refinancing is not always right for everyone and people thinking of refinancing their home should look at what is currently on offer from lenders and do their due diligence. Refinancing makes sense if you can find a lender that will offer a lower interest rate, or if you want a shorter term, or want to switch from an adjustable rate mortgage to a fixed rate mortgage (or vice versa). However, it’s best to consider how much you stand to save to determine if it’s worth it after you factor in the cost of refinancing such as closing cost.
For instance, if interest rates drop from 5% to 4%, a refinancing may be worth it. Also, if you have an adjustable rate mortgage that is set to increase, you may choose to refinance to a fixed rate mortgage.

However, just because you can get a lower interest rate doesn’t mean a refinancing is a good deal. For example, while a drop from 5% to 4% may make refinancing worth it for someone with a $500,000 mortgage, it may not make much sense for someone with less than $100,000 mortgage, especially after factoring in closing cost that can be thousands of dollars.
To determine if a refinancing is worth it, discuss with your financial adviser, check how much you would save overall after the refinancing, and check the break-even point to determine when the refinancing will pay for itself.

In conclusion, interest rate is the major cost of a loan charged by a bank for a refinancing or mortgage loan. APR includes the interest rate, loan fees, and other costs and is the total cost of the loan. It is the best measure when comparing rates across lenders.

 

 

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