Interest rates are up! Interest rates are down! Interest rates have stabilized! It seems like there is a new, and often conflicting, headline about interest rates every week. But what does this ultimately mean for you, and why should you care?
Interest itself is relatively simple. It is what the bank charges you to borrow their money. To pay back a loan plus interest means that you are paying back the money borrowed, plus a fee for the privilege of using it while you had it.
Where it gets tricky is how it is applied, particularly in the mortgage industry. I could write an entire blog post on the intricate details of points, pre-payments, APR, daily interest, prime rate plus whatever, but it is overwhelming. So much so that you probably even skipped over that last sentence halfway through.
All you need to understand about interest for the purposes of a mortgage is the impact that interest rates have on your payment. Again, it is pretty simple – a higher rate equals a higher payment. The bank charges a percentage of the amount you borrowed, calculated on a yearly basis on the amount owed, and then broken up into monthly payments. (This is where fixed rate vs. variable rates come into play, and the length of time of the mortgage. We will address that in a separate post, for today we will just concentrate on the basics.) As an example, let’s say you are borrowing $100,000 for a period of 10 years, and let’s look at the difference the rate can make in your payment.
Disclaimer – there are other factors that go into a payment that we are not going to discuss right now. This is about the loan amount and interest only.
Loan Amount: $100,000/10 years = $10,000 per year that you need to
pay back, called principal
Interest Rate: 10% = $10,000 per year
Payment: $10K principal + $10K interest = $20,000/12 months = $1666.67/month
Now let’s look at this again, with an interest rate of 5%.
Loan amount: $100,000/10 years = $10,000 principal
Interest rate: 5% = $5000/year
Payment: $10k principal + $5K interest = $15,000/12 months = $1250.00/month
That is a difference of $416.67 every month, for 10 years. Over the life of the loan, in the first scenario, you are paying an additional $50,000.04 to borrow that money over and above what you pay in the second scenario. That is a hefty difference, considering the amount borrowed was $100,000.00.
Typically, the interest rates change less than 1% at a time, so the difference will not be this great in your situation. This was just to illustrate the point of why they are important.
This is, very simply put, why interest rates matter. Remember, a higher rate = a higher payment.
In our next post we will discuss some of the factors that can increase or decrease your rate, so make sure to stay tuned!