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4 October 2001, Revised November 11,
2004
Some
of the questions about mortgage interest rates I get from readers are surprisingly basic.
I have to remind myself that one can graduate from college in the US, and
even get a PhD, without ever hearing about interest rates in the classroom.
Most people pick up what they know from experience, which is often an
unreliable teacher.
Here
are some of the questions, starting with the most basic.
"What are mortgage interest
rates?"
An interest rate is the price of money, and a mortgage interest rate is
the price of money loaned against the security of a specific property. The
interest rate is used to calculate the interest payment the borrower owes the
lender.
The
rates quoted by lenders are annual rates. On most home mortgages, the interest
payment is calculated monthly. Hence,
the rate is divided by 12 before calculating the payment.
Take
a 6% rate, for example, and assume a $100,000 loan. In decimals, 6% is .06, and when divided by 12 it is .005.
Multiply .005 times $100,000 and you get $500 as the monthly interest
payment.
Suppose
the borrower pays $600 this month. Then
$500 of it covers the interest and $100 is used to reduce the balance.
One month later, when another payment is due, the balance is $99,900, and
the interest is $499.50. The
interest rate stays the same, but the interest payment is lower because the
balance is lower.
�Which
is more important, the total amount of interest I pay or the interest rate?�
The interest rate is more important in the sense
that the lower the interest rate, the better off the borrower is. You can�t say that about interest payments, which depend not only
on the rate but also on the loan amount and the term. Reduce the loan amount and/or shorten the term and interest payments will
fall. Whether either is in your
interest depends on the circumstances. Reduce
the loan amount and you need to come up with more cash for the down payment. Shorten the term and you have to make a larger monthly payment.
Some
borrowers are bamboozled by this argument and pay a higher interest rate or fees
for a biweekly mortgage that cuts their interest payments. But
the lower interest payments on a biweekly are due to a shortening of the term,
which results from making an extra monthly payment every year.
Borrowers
can reduce the term on their own at no cost, either by taking a shorter term at
the beginning, or by systematically making extra principal payments.
�Does a
fixed mortgage rate always mean a fixed monthly
payment?�
The
�fixed-rate mortgage� or FRM has a fixed payment as well as a fixed rate. However, some FRMs have options such as temporary buydown or �interest-only�
which result in lower payments in the early years. See
What Is a Temporary Buydown?
and What
Is an Interest-Only Mortgage?
And there are graduated payment mortgages which have fixed rates but
rising payments over the first 3 to 10 years.
See What Is a Graduated
Payment Mortgage?
�Can
I borrow at the rates quoted in the media?�
Probably
not. The quoted rates are based on
numerous assumptions, such as that your credit is good, you have enough income
to qualify, you can document your income and assets, you will occupy the house
as your primary residence, and on and on. If
you don�t meet all the assumptions, your rate will be higher.
See
What Market Niche Are You In?
In
addition, the quoted rates apply today. Rates
are reset every day, so tomorrow they may be different.
What matters are the rates quoted on the day you lock the terms of the
loan.
See
Can I Avoid Mortgage Prices That Have Lapsed?
Furthermore,
not all rate quotes are believable. Some
loan providers deliberately quote below the market to get borrowers in the door.
Once inside, they are fair game for a variety of stratagems for raising
the rate. See
Can I Rely on Mortgage Price Quotes?
Copyright
Jack Guttentag 2004
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