How Interest on Mortgages are Calculated

The way interest on mortgage is calculated depends on many different factors, including the mortgage term and how the interest is compounded. Some mortgages have fees and some mortgages have points- both have an effect on the way interest is calculated. The differences make it very complicated to compare one type of mortgage to another, but it is possible to make educated comparisons when you use the annual percentage rate (APR). The annual percentage rate includes all loan costs and fees, such as points, private mortgage insurance premiums, origination fees, etc. The APR is the average of the yearly finance charge divided by the amount of money borrowed. The annual percentage rate is calculated in the same manner regardless of the other terms of the mortgage. So whether you are looking at a 30 year fixed rate mortgage at 7 percentage interest and no points or a 20 year adjustable rate mortgage at 5.5 percent interest- the APR will be calculated the same for both. The total of all fees (application fee, points, closing fees, etc) are deducted from the actual mortgage loan amount to get the “true cost” of the loan. Then, you can determine the actual interest rate by finding out what rate would equate to the loan’s monthly payment for the loan of your “true cost” amount. For example, if you are borrowing $120,000, and the monthly payment is $880.52, and the fees and points add up to be $3,015- you would subtract $3,015 from $120,000 to get the true cost of your loan. The true cost of this loan would be $116,985. This is the amount used to determine the APR, which in this case, would be 8.38%. The APR is usually higher than the interest rate the lender is charging as it reflects the yearly rate. You don’t have to figure out the APR on any mortgage, however, all you need to do is ask. The Federal Truth in Lending Disclosure requires that the APR is given to you. What you need to find out is which fees are included within the APR calculation, to compare one mortgage to another to find your best option. If you sell your home, or refinance your mortgage a few years after you obtain your loan, the interest rate is going to be higher than if you kept your mortgage the full 30 years. Additionally, the more money you finance in your mortgage, the less of an impact the fees actually have on the annual percentage rate. This is because the APR uses the entire loan amount in its calculation. When you want to compare one mortgage to another, it’s important that you use the annual percentage rate to make an educated comparison. Even mortgages that appear to be the same as far as the length of time you have to pay, and the advertised interest rate may have very different effects on your wallet because the fees and points may not be disclosed!