Mortgages are advertised with two different rates. The first is usually called simply the "interest rate." This is the rate used to calculate your monthly payments. The second is called the "annual percentage rate," or APR. Most loans come with costs beyond the interest you pay, such as origination fees, application fees and prepaid interest "points." The APR tells you what the effective rate on the mortgage would be if all those extra costs were charged as interest, which is why the APR is always higher than the stated interest rate. More than anything, APR is there to help you compare loans. Lenders are required by law to provide an APR, even though it doesn't affect your monthly payments.

 

How Interest Rates Are Determined
Mortgage lenders display their interest rates prominently, but they seldom explain exactly how these rates work. When you take out a mortgage, your lender determines the rate of interest you’ll be charged for a portion of, or for the duration of your loan. This rate is heavily influenced by the overall economy’s interest rates.

When a bank loans someone money, it must pay an interest rate back to the Federal Reserve Bank, the central banking system of the United States. Think of it like this: if the bank is your lender, then the Fed is the bank’s lender. Since these interest rates move all the time, the bank is constantly exposed to price risks that will shape how much money it loans out, and at what rate.

 

Mortgage rates rise and fall along with interest rates. When banks use interest rate futures to manage their interest rate exposure, they are better able to give you a lower mortgage rate because they’ve already locked in their own short- or long-term interest rate. By the same token, this certainly allows them to loan more money to more people and businesses.

 

Mortgage Interest Rates
The interest on nearly all mortgages is computed monthly, so you divide the annual rate by 12 to get the monthly rate. For example, if you were to take out a $200,000 mortgage for 30 years at, say, 7.5 percent interest, your monthly payment would be about $1,400. How does the 7.5 percent interest factor into that? The answer is that your annual percentage rate gets broken down into a monthly rate, which is applied to your monthly balance.  Therefore, in the case of this mortgage, 7.5 divided by 12 equals a monthly rate of 0.625 percent. Every month, you pay 0.625 percent interest on your principal balance (the amount you actually owe on the house). When it comes time to make your first monthly mortgage payment, your principal balance is $200,000. Applying the monthly rate--0.625 percent--to that amount gives you an interest charge of $1,250 for the first month. That's only part of your first month's payment, though. You'll also pay off a little of the principal. The next month, because the principal is a little smaller, your interest charge will be a little smaller--which means you can afford to pay a little bit more of the principal.

 

Lenders use a special formula called an "amortization formula" to create a schedule of payments so that every month the total amount you pay in interest plus principal comes out the same. For the mortgage loan example explained above, your monthly payment would be $1,398.43. The first month, it's divided into $1,250 in interest and $148.43 in principal. In the second month, the principal is now down to $199,851.57. Multiply that by the monthly rate of 0.625 percent, and you get an interest charge of $1,249.07. You'll also pay $149.36 in principal, for a total payment of $1,398.43. the same as in the first month. In the third month, the principal is $199,702.21. Your interest charge is $1,248.14, added to a principal payment of $150.29 for a total payment of, once again, $1,398.43. This continues for the life of the loan. Each month, the interest charge gets smaller and the principal payment gets larger until you've paid off all the principal and the house is yours.

 

Types Of Mortgage Rates
There are two different types of mortgage interest rates, fixed interest rates, and adjusted rate mortgage, (ARM). The calculations above were based on a fixed-rate mortgage but an adjustable-rate mortgage works much the same way.

 

Fixed Rate Mortgages:
A fixed mortgage rate is the most popular option because the rate remains the same throughout the entire life of the mortgage loan. These loans represent over 75% of all home loans. They usually come in terms of 30, 15, or 10 years, with the 30-year option being the most popular. While the 30-year option is the most popular, a 15-year builds equity much faster. The obvious advantage to having a fixed rate is that the homeowner knows exactly what the interest and principal payments will be for the length of the loan. This allows the homeowner to budget easier because they know that the interest rate will never change for the duration of the loan. When rates are high and the homeowner acquires a fixed rate mortgage, the homeowner is later able to refinance when the rates go down. If the interest rates go down and the homeowner wants to refinance, the closing costs must be paid in order to do so. Some banks wishing to keep a good customer account may waive closing costs. If a buyer buys when rates are low they keep that rate locked in even if the overall economy’s interest rate rises.

 

Adjustable Rate Mortgages (ARM):
Adjustable rate or variable rate interest loans allow the mortgage lender to set the interest rate to whatever market conditions demand at any given time during the life of the mortgage. The attraction of adjustable interest rate mortgages is that you can benefit from any future drop in market interest rates, as your monthly mortgage repayments will be reduced to reflect the market changes. However, the opposite also holds true and if the market decides it's time for interest rates to rise so too will your mortgage repayments. Make sure you fully understand the consequences of an adjustable interest rate loan if you are considering taking one out. If interest rates rise dramatically you could find yourself in financial difficulties, so take the time to work out what your repayments would be if the interest rates were to double at some point. At least then you'd have an idea of what your mortgage loan might end up costing you.

 

One Year ARMs:
Obtaining a one-year adjustable rate mortgage can allow the customer to qualify for a loan amount that is higher and therefore acquires a more valuable home. Many homeowners with extremely large mortgages can get the one-year adjustable rate mortgages and refinance them each year. The low rate lets them buy a more expensive home, and they pay a lower mortgage payment so long as interest rates do not rise.

 

Mixed Fixed Rate And Adjustable/Variable Rate Mortgages
In many cases, it is possible to arrange a mortgage where you have both a fixed interest rate and an adjustable interest rate. For a set period of time, say the first 3 years, the interest rate is fixed. After this period the mortgage reverts to a typical variable rate. The major benefit from this type of arrangement is that it enables many mortgage holders the opportunity to know exactly what their mortgage is going to cost for the first few years so they can budget accordingly. Typically, the interest rate offered for the 'fixed' portion of the term of the mortgage will be slightly higher than the variable rate. This is the bank's way of hedging their bet, so to speak, but it's generally not much higher than the current variable rate. If interest rates rise over the period of time that your mortgage rate is fixed your interest payments will be unaffected by the rise. If they remain high past the expiration date of your fixed period then you will revert to the higher rate at that time and, conversely, if the interest rates go lower you'll revert to the lower rate.

 

A Few Examples Of Mixed Fixed And Adjustable Rate Mortgages -
 

10/1 ARMs:
The 10/1 ARM has an initial interest rate that is fixed for the first ten years of the loan. After the 10 years is up, the rate then adjusts each year for the remainder of the loan. The loan has a life of 30 years, so the homeowner will experience the initial stability of a 30-year mortgage at a cost that is lower than a fixed rate mortgage of the same term. However, the ARM may not be the best choice for those planning on owning the same home for over 10 years unless they regularly make extra payments & plan on paying off their loan early.
 

5/5 And 5/1 ARMs:
The 5/5 and the 5/1 adjustable rate mortgages are amongst the other types of ARMs in which the monthly payment and the interest rate does not change for 5 years. The beginning of the 6th year is when every 5 years the interest rate is adjusted. That’s every year for the 5/1 ARM and every 5 years for the 5/5. These particular ARMs are best if the homeowner plans on living in the home for a period greater than 5 years and can accept the changes later on.

 

5/25 ARMs:
The 5/25 mortgage is also called a “30 due in 5” mortgage and is where the monthly payment and interest rate do not change for 5 years. At the beginning of the 6th year, the interest rate is adjusted in accordance with the current interest rate. This means the payment will not change for the remainder of the loan. This is a good loan if the homeowner can tolerate a single change of payment during the loan period.

 

3/3 And 3/1 ARMs:
Mortgages, where the monthly payment and interest rate remains the same for 3 years, are called 3/3 and 3/1 ARMs. At the beginning of the 4th year, the interest rate is changed every three years. That is 3 years for the 3/3 ARM and each year for the 3/1 ARM. This is the type of mortgage that is good for those considering an adjustable rate at the three-year mark.

 

Balloon Mortgages
Balloon mortgages last for a much shorter term and work a lot like a fixed-rate mortgage. The monthly payments are lower because of a large balloon payment at the end of the loan. The reason why the payments are lower is that it is primarily interest that is being paid monthly. Balloon mortgages are great for responsible borrowers with the intentions of selling the home before the due date of the balloon payment. However, homeowners can run into big trouble if they cannot afford the balloon payment, especially if they are required to refinance the balloon payment through the lender of the original loan.