How to Calculate Interest When Home Buying

Understanding Home Interest RatesWhen buying a home with a mortgage, there are many factors that come into play that effect the monthly mortgage payment. One of the most important is the mortgage interest rate. The interest rate each individual home buyer receives is based on a variety of financial data, such as the buyer's credit score, assets, and debt. Home buyers should understand the basics behind interest rates and amortization formulas, but they should also know about the other factors that can help or hurt them when it comes to paying off their debt - prior to obtaining a mortgage.

For informational purposes only. Always consult with a licensed mortgage professional before proceeding with any real estate transaction.

Amortization Basics

Amortization formulas tell a homeowner what they'll pay over the course of the loan, and includes the following factors:

  • Principal
  • Length of the loan
  • Interest rates
  • Type of loan

When shopping for loans, buyers are given an annual interest rate. The interest rate a San Pedro home buyer receives depends on the buyer's personal financial history, the type of loan, and the federal interest rates dictated by the government. If the buyer is offered 4% on a $200,000 loan, they'll pay this amount of annual interest over the life of the loan. Most mortgage loans are for 30 years. The longer the length of the loan, the more interest a buyer will pay.

Amortized Interest

In loan amortization, any loan over one year typically is amortized. A monthly mortgage payment may be the same each month for the 30 year period, but each payment will have a different interest and principal amount - though each added up will equal the same amount each month. The highest amount of interest paid begins with the first payment with each payment decreasing the amount of interest - while increasing the amount of principal.

Since mostly interest is paid for the first few years of an amortized mortgage, homeowners are often encouraged to pay additional principal at the beginning of the loan - in addition to the regular mortgage payment. This strategy can will usually pay off the loan faster, which will allow homeowners to save more interest expense over time. Buyers who itemize their federal tax returns are also allowed to deduct a certain amount of mortgage interest payments, subject to certain limitations. A home buyer may also be able to take advantage of the deduction of mortgage interest on state tax returns as well, though rules vary based on the state in which the property is located.

Fixed and Adjustable Interest Rates

A fixed rate mortgage will have the same mortgage payments over the course of the loan, while an adjustable-rate mortgage (ARM) will fluctuate based on federal interest rates. An ARM mortgage loan typically features excellent rates upfront, which is why they're popular among home buyers when interest rates are high. However, home buyers should be aware that most ARM mortgage loans do increase the interest rate (and therefore the monthly mortgage) over time. That's why some buyers prefer a fixed interest rate loan. Fixed rate mortgages may be a higher rate initially, but in a period of rising interest rates, the fixed rate may actually become the lower rate. In addition, fixed rate mortgages assist homebuyers to budget the cost of their mortgage.

Other Considerations

Lenders try to mitigate the risks of buyer default however they can, so home buyers need to be aware of additional costs besides interest rates. One way lenders protect from buyer default is with Private Mortgage Insurance (PMI). PMI is usually required from lenders who put down less than 20% as a down payment on the price of a home. PMI is essentially an insurance policy that home buyers pay the lender until they do reach 20% equity in their home. This is accomplished either through principal payments and/or home values increasing. Sometimes buyers are offered interest-only loans with low monthly payments.

Home buyers should also watch for lenders offering interest-only loans. In the case of an interest-only loan, homeowners will only pay interest during the first several years of the loan. These loans are usually recommended for those buyers who may sell the home quickly or to those with irregular income. While the original monthly payments are excellent for interest-only loans, they can steadily increase if the buyer has an ARM. Plus, the buyer will still continue paying interest over the course of the loan as they work toward paying down the actual principal.

Each buyer's interest rate will differ based on their specific financial situation, the type of loan they choose, and the state of the national economy. Buyers who want to pay less for their home over time should understand how their particular rate is calculated by their lender before choosing settling the final details of their mortgage.

For informational purposes only. Always consult with a licensed mortgage professional before proceeding with any real estate transaction.

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