Understand Interest Rates and How They Impact Your Mortgage

When taking out loans to buy homes, homebuyers must carefully consider the interest rates on their mortgages.  Interest rates determine the cost of loans. They can also regulate the rate of growth of the national economy. The Federal Reserve manages interest rates to accelerate or slow down economic activities in the country.

What Is an Interest Rate?

An interest rate is a percentage of a loan that the lender charges as a cost for lending you money. You lend money to the bank when you deposit money. The bank pays you interest, calculated per annum, based on the amount you deposited. 

When you take out a mortgage, the bank, as a lender, obliges you to pay interest on top of the principal amount of your home loan. 

How Do Interest Rates Work?

The principle of interest rates applies to most loans, whether they be mortgages, car loans, or credit card debt.

Interest rates applied to your loans are added to the remaining unpaid balance each period. You must pay at least the interest during each compounding period. Failing to do so can increase your outstanding debt even if you make regular payments.

Interest rates for different types of loans vary. Revolving loans, such as those afforded by credit cards, tend to carry high-interest rates because these loans are more expensive to manage.

Banks also evaluate their risk for lending when determining interest rates on mortgages and other major loans. They usually charge higher interest rates for people with low credit scores or riskier business ventures.

Two Types of Interest Rates: Fixed And Variable

Fixed interest rates are locked for the entire term of the loan. Fixed-rate mortgages are the safest to avail of because rates on these loans do not increase even during inflation. This makes it easier to plan your finances since your monthly mortgage payments remain relatively consistent. 

Initially, you pay the interest only. The amount on your mortgage increases only when it is time to include paying some of the debt principal.

In contrast, variable rates change when the prime rate changes. The prime rate is largely affected, in turn, by the fed funds rate.  When the Fed raises the fed funds rate, the prime rate follows, and the variable interest rate on your mortgage also increases. 

Although variable rates typically start enticingly low, they fluctuate over time, making mortgages challenging to manage. 

What Factors Decide Interest Rates?

 Treasury note yields or the fed funds rate determines the interest rates. 

The fed funds rate often influences the interest rates on short-term loans. But it also affects variable-rate mortgages. Increases in the fed funds rate also raise variable-rate home loans, making housing loans more costly. 

Treasury note yields directly affect fixed-rate loans. For instance, low-yielding Treasury notes often mean lower fixed-mortgage interest rates, creating a conducive economic environment for buying and selling homes.  

What Is The Interest Rate Effect: High vs. Low

The Federal Reserve uses interest rates to keep inflation manageable. Raising and lowering interest rates have a cascade effect on other interest rates, so both actions are necessary monetary policies to help stabilize the economy.

The Fed lowers the fed funds rates if it wants to stimulate consumerism and economic expansion. Low mortgage interest rates make housing loans more attractive and increase the demand for real estate. 

Note: Although low interest rates seem preferable, low rates can cause inflation by increasing money supply. Because liquidity is high, demand will eventually outstrip supply and cause prices to rise. Inflation then sets in and has to be managed by increasing interest rates. 

When the Fed wants to slow consumer demand and economic growth, it raises interest rates. Mortgage rate increases discourage home loans and reduce the demand for real estate.

Evaluate Mortgage Costs by Understanding Interest Rates vs. APR 

When comparing different mortgage offers, you will encounter two key factors: the mortgage interest rate and the annual percentage rate (APR).

The mortgage interest rate determines your monthly payment.

While mortgage interest rates and the APR refer to borrowing costs, the APR differs from the mortgage interest rate as it reveals the total cost of the home loan over its lifespan. 

It includes the interest rates on the mortgage and additional costs such as broker fees, closing costs, and points. Points take the largest share of the cost as one-time fees.

The APR is usually higher than your interest rate. 

Note: Use the APR to compare total home loan costs. 

Let’s compare two different home loan options and calculate the break-even point. The break-even figure tells you when or at what point in time the costs of the two loans become equal. 

Loan Option 1:

Loan Option 2:

At first glance, Option 2 seems to be the better offer, despite its higher points and fees. Its interest rate and APR rate are lower than that of Option 1. 

But by computing the break-even point, we will discover which option is optimal in the period we plan to pay the mortgage. 

Loan Option 2 becomes more cost-effective if you stay on the loan for over 3.8 years because of its low APR. But, if you foresee moving out or refinancing within the first 3.8 years, Loan Option 1, with the higher interest rate and lower points, would be the better choice as you save on upfront costs.

In A Nutshell

Interest rates are critical in the real estate market and the overall economy.

Low-interest rates may favor the real estate market, leading to more affordable home loans and increased demand for homes. But perpetually low-interest rates can also overheat the economic pace and cause inflation. 

Inflation creates a situation where prices climb and demand drops. 

The Fed manages inflation and the rate of economic growth by controlling interest rates through the fed funds rate.

Remember to consider the APR when comparing mortgage offers, as it gives you a more comprehensive view of the total cost of the loan. 

The more informed you are about interest rates and APR, the better equipped you will be to make smart financial choices when buying or selling a home. Stay updated on the Federal Reserve’s announcements on rate changes to help you navigate real estate more effectively.