Have you ever said to yourself, "I'm not really sure how interest rates even work?"
No need to worry — that's what we're here for! You are definitely not alone. This is complicated stuff. So in today’s ‘Language of the Loan’ series, we’re going to break down exactly what an interest rate is, and how it affects you as a homebuyer.
Let’s start simple. The textbook definition of an interest rate reads as follows:
The annualized cost of credit or debt-capital computed as the percentage ratio of interest to the principal.
Let’s try and simplify it a bit. How about:
An interest rate is the proportion of a loan that is charged as interest to the borrower, expressed as an annual percentage of the amount outstanding.
Still kind of hard to wrap your head around, isn't it? There are no easy answers here. The best way to understand rates are to break them down into their base components, and then relate them by using real life circumstances.
Everyone qualifies for a mortgage differently. Your own interest rate on a mortgage will be the product of three major factors: the current base rate (or the federal funds rate), your lender’s product and policies, and your own credit history.
Now, the base rate is determined by the market, nothing you can do about it. And a lender’s products and their price are typically affected by the base rate. The part you can control is your own financial history, which is how a lender determines your risk as a borrower, and therefore your particular interest rate. If you have a clean financial history, solid income, and good credit, your mortgage rate will be lower.
Now let's look at the average mortgage bill. Your monthly mortgage payment is broken down into two pieces, principal and interest. Principal is the money that you originally agreed to pay back to the lender. So if you took out a $250,000 loan, that $250k is only the total amount of principal you owe back. Since nothing is given for free, this is where your interest rate comes in to play. Interest is essentially the cost of borrowing money. That cost is determined by your lender, and expressed in a percentage. Right now the average rate on a 30-yr. fixed mortgage is hovering well below 4.00%. But we like round numbers, so let's use 4.00% for this scenario.
We apply this percentage to a hypothetical loan situation: you borrow $250,000, and qualify for a 4.00% interest rate from your lender. That means that, on a fixed rate 30-year mortgage, your monthly mortgage principal and interest payment would come to $1,194.
Now let's say the rate drops a quarter, down to 3.75%. A loan of $250,000 at 3.75% on a fixed 30-year now brings your monthly payment to $1,158 - or a decrease of $36. That may not seem like much - but that depends on how much money you need to borrow!
Make sure that you keep in constant contact with your Loan Officer, as rates change daily. What looks like small changes can actually affect your ability to qualify for a mortgage. Your Midwest Lending mortgage professional will lock you in with the right lender, the right mortgage product, and the best rate you can qualify for.