How Do Interest Rates Work?

Interest rates, simplified:  

An interest rate is the “price” a lender charges a borrower for a loan. Just like a pair of jeans at your favorite store, every loan has a price tag. That price tag is the interest rate. But instead of dollars and cents, the price of borrowing a sum of money is a percentage of the total amount borrowed.  Interest rates rise and fall daily based on loan type (rates are typically lower for shorter-term loans), what the Feds are doing (the U.S. central bank), and, yes, inflation. 

How Mortgage Payments Are Calculated

With most mortgages, you pay back a portion of the amount you borrowed (the principal) plus interest every month. Your lender will use an amortization formula to create a payment schedule that breaks down each payment into principal and interest.

If you make payments according to the loan's schedule, the loan will be fully paid off by the end of its set term, such as 30 years. If the mortgage is a fixed-rate loan, each payment will be an equal dollar amount. If the mortgage is an adjustable-rate loan, the payment will change periodically as the interest rate on the loan changes.

Fixed-Rate vs. Adjustable-Rate Mortgages

Banks and lenders primarily offer two basic types of loans: 

• Fixed rate: The interest rate does not change.
• Adjustable rate: The interest rate will change under defined conditions (also called a variable-rate or hybrid loan).

Don't Forget Taxes, Insurance, and Other Costs

If you're buying a home, you'll also need to consider some other items that can significantly add to your monthly mortgage payment, even if you manage to get a great interest rate on the loan itself. For example, your lender may require that you pay for your real estate taxes and insurance as part of your mortgage payment. The money will go into an escrow account, and your lender will pay the bills as they come due. These costs are not fixed and can rise over time. Your lender will itemize any additional costs as part of your mortgage agreement and recalculate them periodically.

Want to run the numbers to see what you could afford this January, or have other questions about buying or selling? Reach out! We'd love to hear from you, and answer any questions you may have.