What Are The Different Types Of Interest?

If you’re in the market for a mortgage, the offers and figures thrown at you can be dizzying. The process can be so confusing that you might feel tempted to work with the first lender who offers you a loan. First-time homebuyers especially can feel overwhelmed.

Although obtaining a mortgage and buying a home can seem intimidating, you can lose tens of thousands of dollars by rushing through or keeping your head in the sand. Instead, take a few minutes with this straightforward guide to types of interest on mortgages. By educating yourself on how lenders calculate and offer different types of interest rates on mortgage loans, you’ll better understand how to select a mortgage that fits your financial situation.

How Many Types Of Interest Rates Are There?

Every savings vehicle and loan involves an interest rate. Across the economy, there are different terms for these different types of rates. Concerning mortgages, there are eight types of interest rates.

These eight interest rates combine to influence the interest rate a lender offers a homebuyer. Therefore, when you are looking to buy a house and applying for a mortgage, it’s crucial to understand the various rates and know how to pick which is best for you.

The types of interest rates for mortgages are:

What Is Interest?

Interest refers to two connected but dissimilar elements in the financial world. The first is the amount a lender charges a borrower for a loan. The borrower essentially pays the lender a percentage of the loan for the ability to borrow money.

The second circumstance in which interest is involved is your bank account and certain investment accounts. Your bank will pay you interest on the funds in your account. The bank pays this percentage on your account for the ability to hold and use your money.

How Are Mortgage Interest Rates Set?

Rather than tailoring mortgage interest rates to each borrower’s financial circumstances, lenders use interest rates consistent throughout the entire real estate market. While some borrowers may receive slightly better interest rates for an excellent credit score, the basis and limitations for interest rates result from macroeconomic factors and the functions of governing bodies, such as the Federal Reserve.

Discount Rate

In the U.S. economy, the market sets the interest rates. However, Federal Reserve (the Fed) – our nation’s central bank – balances market forces by influencing the amount of money in the economy.

For example, the Fed controls the discount rate, which it charges on the loans it makes to banks and other financial institutions. The Fed redetermines this rate every 14 days to address trends or fluctuations in the economy. The discount rate is the only rate the Fed controls directly.

Prime Rate

The prime rate is one of the most common standards for credit card and home equity line of credit rates. It correlates with the federal funds rate, which the Federal Reserve controls. The prime rate is approximately 3% higher than the federal funds rate, which banks charge each other when one lends money to another.

The percentage hike exists because lenders see consumer loans as riskier than loans to fellow corporations. That said, a mortgage is less costly than other consumer loans because if a borrower defaults on their mortgage, the lender can repossess the house.

Financial Characteristics

Transcendent economic factors will always play a significant role in what mortgage interest rates are available. However, a borrower’s financial circumstances will influence the interest rate a lender will ultimately offer them.

For example, a borrower’s credit score will affect the final interest rate a lender offers. A credit score of 670 or higher will reduce the interest rate on the mortgage. The higher the credit score, the better the discount.

Furthermore, your lender will consider your debt-to-income ratio (DTI) when offering you a loan. This calculation is based on your monthly debt payments divided by your monthly income. The upper limit for your DTI is usually 43%. A DTI of 35% or less may earn you a decreased interest rate.

Lastly, your income and assets help the lender see how likely you are to pay back your mortgage. Borrowers with high surpluses of cash, investment accounts and real estate have greater financial capacity than borrowers with a meager bank account and no assets.

How Are Interest Payments Calculated?

You can calculate interest payments by using the terms of the loan and the type of interest the loan has. After confirming the type of interest your lender offers, you can use the corresponding section below to calculate your interest payment.

Simple Interest

Simple interest is the easiest interest type to understand. You can calculate simple interest using this formula:

Simple Interest = (Principal Balance) ✕ (Interest Rate) ✕ (# of Pay Periods)

For example, you might borrow $200,000 for your mortgage at a 5.5% simple interest rate to be repaid over 20 years. Using the simple interest formula, you can calculate your loan cost:

$200,000 (principal balance) x 0.055 (interest rate) x 20 = $220,000. Therefore, you will pay $220,000 in interest over the life of the mortgage. By adding the interest payments and the principal, you can see that you will pay $420,000 total for the mortgage after 20 years.

Compound Interest

With compound interest, interest on debt or an investment compounds on a set period of time.

For example, if you have a $50,000 investment that gains 5% interest and compounds yearly, after 20 years you would have $132,664.89. To calculate compound interest, use this formula:

A = P (1 + r ∕ n)^(nt)

Where:

Or instead of writing it out yourself, you can use a compound interest calculator. When it comes to debt, compound interest is mostly used on credit cards. With mortgages, you’re more likely to see mortgage amortization than compound interest.

What Rates Are Offered By Mortgage Lenders?

In this section, the types of interest rates mortgage lenders offer are split into fixed-rate and adjustable-rate interest. Remember that lenders are vying for your business and will advertise deals and discounts to get you in the door. Therefore, it pays to shop around in a competitive market instead of taking the first offer that sounds good to you. Gathering multiple options and evaluating them is how you’ll secure yourself the mortgage that best suits your financial circumstances.

Fixed-Rate Mortgage

Fixed rates are the most popular type of interest rate for a mortgage. As the name implies, the interest rate never changes, allowing the borrower to make steady, predictable monthly payments. Typically, fixed interest mortgages have terms of 15 years or 30 years , but some lenders allow for wider ranges.

A fixed-rate mortgage provides the borrower with an affordable, predictable mortgage that they can pay off faster with no penalty. However, a 30-year mortgage will charge sizable interest over that long of a period. So, if you have plans to move a decade or less into your mortgage or want to build equity quickly, a fixed-rate mortgage might be a subpar option.

Adjustable-Rate Mortgage (ARM)

An adjustable-rate mortgage (ARM), also called a variable-rate mortgage, will match an index rate and then follow that rate throughout the life of the loan. For example, the loan might match the Prime Interest Rate. The interest the borrower pays will depend on the Prime Rate as the Federal Reserve changes it. Consequently, the borrower could experience savings or be hit by extra charges if the interest rate spikes.  

ARMs work by giving a borrower a fixed rate (known as an initial rate) to begin. Then, further into the loan, the interest rate follows an index and resets at designated intervals, such as yearly or monthly. Therefore, ARMs are a hybrid product, not a true variable interest loan.

How Can Consumers Compare Interest Rates Across Loan Offers?

Lenders try to distinguish between themselves to borrowers by advertising the lowest interest rates. However, don’t let a low interest rate hook you immediately – some lenders add fees to subsidize those low interest rates. Read through the details of the offer from lenders you are considering to ensure you understand what you’ll be paying and why.

Annual Percentage Rate (APR)

Annual percentage rate (APR) is a way for borrowers to know exactly how much their mortgage will cost. APR is more accurate because it incorporates the interest rate and loan origination costs into the final number. However, APR only applies to simple interest loan types.

Because APR is more precise than just the interest rate, borrowers can use it to compare one loan offer to another. All consumer credit offers must include APR. When borrowers shop around for the best deals when getting a mortgage, housing giant Freddie Mac estimates that just one call can save consumers $1,500, while getting five quotes can save as much as $3,000.

Annual Percentage Yield (APY)

Like APR, annual percentage yield (APY) isn’t technically an interest rate. Instead, it operates similarly to APR but is used to show how much money you’ll make through compound interest on investment vehicles. Therefore, APY is a better figure than the interest rate for consumers to use when comparing CDs or money market accounts because it shows how your wealth benefits from compounding interest.

APR and APY apply to financial instruments other than mortgages, but they matter just as much to your financial health. APR will determine how much you pay for your sources of revolving credit. For example, your lender will charge interest on credit card debt and home equity lines of credit (HELOC) at a variable rate. Since every lender discloses the APR of their products, you can shop around for the revolving line of credit that suits you.

A product’s APR is an excellent way to see how much a variable interest rate can cost you. Unlike an ARM, in which the borrower initially receives a low, fixed interest rate, a true variable interest rate on a credit card, for example, applies to consumer debt from the outset.

The Bottom Line: Interest Rates Are The Cost Of Borrowing Money

If you’re in the market for a mortgage, you’ll quickly see that lenders calculate interest rates in myriad ways to monetize the practice of lending money. However, with this guide at hand, you’ll be able to understand how different types of interest rates work and effectively shop for the loan that works for you.