Why are Interest Rates So Important?

by | May 7, 2018

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Interest rates are incredibly important to a mortgage. They dictate how much extra money one pays in addition to their loan amount. Interest is usually added when borrowing money to make a large purchase, or borrowing money in general.

Important Things to Know about Interest Rates

How does one calculate interest? Is it calculated by taking the interest rate and multiplying it by the entire loan amount? It makes sense since houses aren’t cheap and the interest would cost you thousands of dollars.  Many first time buyers don’t understand that the interest rate on your mortgage is actually a monthly interest rate.

In order to calculate how much the interest rate affects your mortgage, take the interest rate and divide it by 12. This is for the 12 months in a year. Now let’s say that you took out a loan for $100,000 and the interest rate is 3%. When you do the math, 3% of $100,000 is only three thousand dollars. Unfortunately, you would not only be paying three thousand dollars in interest.

If you were to turn that 3% into a monthly rate, you would divide it by 12 (3%/12), which comes out to .0025. Now, take that number and multiply it by the principal. The resulting number is how much interest you would pay for that month. In this particular example, the interest due for the first month is already $250. This calculation only works for fixed interest rate loans since they are amortized. Depending on the term you’ve chosen,this means that interest will cost well over the $3,000 you initially thought you were paying.

Why are There Two Interest Rates?

When looking at different rates that the lenders have to offer, you will always see two sets of interest rates side by side. One will be labeled as the “interest rate” and the other will be labeled as the “APR.” Sometimes, both rates will be identical to each other and other times, there is a slight difference. The term “APR” stands for Annual Percentage Rate and gives the mortgagee a clearer idea of what the loan will actually cost them in the first year.

The APR does not have any effect on your monthly payment. If you see two different sets of numbers, the APR will most likely be higher. This is usually because the loan will require discount points and origination fees upfront.

Overall Thoughts

It is important to be aware of these tiny details before purchasing a home so that you know what you’re getting yourself into. That small difference between monthly interest rate and overall interest rate can better prepare home buyers for their mortgage.

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