Understanding Interest Rates in Real Estate

Interest rates are one of the most confusing aspects of the home buying process. Here are a few facts to help you understand how real estate interest works.

How Do Interest Rates Work?
Let’s say that you qualify for an annual interest rate of 7.5%. Interest is calculated monthly, so divide that number by 12 to get a monthly rate of 0.625%. This is the amount of interest you will pay each month.

If you have looked at an amortization chart, you will have noticed that the amount if interest you pay each month goes down while the amount paid towards principal goes up. That is because the 0.625% rate is applied to the total principal of the loan every month. As the total principal goes down, so do your interest payments.

What is an Adjustable Rate Mortgage?
An adjustable rate mortgage, or ARM, is a loan product that does not have a guaranteed interest rate for the entire term of the loan. The rate stays the same during the first part of the loan, or the ‘initial rate period’ but it is subject to change after that. An ARM does come with a few advantages.

You can generally get lower interest rates and thus lower monthly payments during the initial rate period, which is good if you plan to resell quickly. Another advantage is that after the initial rate period, you will save money if interest rates drop further. However, remember, the rates could also rise.

Fixed Rate Loans
With a fixed rate mortgage, rates and payments will stay the same for the entire loan term, which makes it easier to understand and build a budget. It’s a good option for someone who plans to stay put for a long time. However, if interest rates fall, you will have to refinance to get the lower rates.

How do Discount Points Work?
Discount points are a fee you can pay to lower your interest rate. Each point costs 1% of the amount you borrow. When you buy a point, your interest drops by one-eighth to one-quarter of a percent.

For example, if you borrow $200,000 with an interest rate of 5.5% and you purchase one point, which would cost you $2000, your interest rate will lower to 5.25%. This will save $31 per month on a 20-year mortgage.

Whatever type of mortgage product you choose depends on your plans for the future. Understanding the fundamentals will help you make an informed decision.