A Beginner's Guide to Understanding Home Interest Rates

Times Staff Writer

You can graduate from college without ever hearing about interest rates in the classroom. Most people pick up what they know from experience, which is often an unreliable teacher.

Here are some reader questions about interest rates, starting with the most basic.

Question: What are these numbers, like 6.0 and 6.50, that I see in the mortgage ads? Answer: Those numbers are mortgage interest rates. An interest rate is the price of money, and a mortgage interest rate is the price of money loaned against the security of a specific property.

The interest rate is used to calculate the interest payment the borrower owes the lender. The rates you see quoted are annual rates. On most home mortgages, the interest payment is calculated monthly. Hence, the rate is divided by 12 before calculating the payment. Take a 6% rate, for example, and assume a new $100,000 loan. In decimals, 6% is 0.06, and when divided by 12 it is 0.005. Multiply 0.005 times $100,000 and you get $500 as the interest payment in the first month.

Suppose the borrower pays $600 this month. Then $500 of it covers the interest and $100 is used to reduce the balance. One month later, when another payment is due, the balance is $99,900, and the interest is $499.50. The interest rate stays the same, but the interest payment is lower because the balance is lower. In the second month, $100.50 is available to reduce the balance.

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Q: My loan officer says that what is important is the total amount of interest I pay over the life of the loan, not the interest rate. Do you agree?

A: No. The lower the interest rate you pay, the better off you are. But you can't say that about interest payments, which depend not only on the rate but also on the loan amount and the term. Reduce the loan amount and/or shorten the term and interest payments will fall.

Whether either is in your interest depends on the circumstances. Reduce the loan amount and you need to come up with more cash for the down payment. Shorten the term and you have to make a larger monthly payment.

Some borrowers are bamboozled by the argument that what matters is interest payments. They agree to pay a higher interest rate or fees for a biweekly mortgage that cuts their interest payments. But the lower interest payments on a biweekly are due to a shortening of the term, which results from making an extra monthly payment every year. Borrowers can reduce the term on their own at no cost, either by taking a shorter term at the beginning or by systematically making extra principal payments.

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Q: If the interest rate on a mortgage is fixed, does that mean that the monthly payment is fixed?

A: The "fixed-rate mortgage" has a fixed payment as well as a fixed rate. However, some have options, such as temporary "buy-downs" or "interest only," that result in lower payments in the early years. And there are graduated-payment mortgages that have fixed rates but rising payments over the first three to 10 years.

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Q: Can I borrow at the rates I see quoted in the media?

A: Probably not. The quoted rates are based on numerous assumptions, such as that your credit is good, you have enough income to qualify, you can document your income and assets, you will occupy the house as your primary residence, and on and on. If you don't meet all the assumptions, your rate will be higher.

In addition, the quoted rates apply today. Rates are reset every day, so tomorrow they may be different. What matters are the rates quoted on the day you lock the terms of the loan.

Furthermore, not all rate quotes are believable. Some loan providers deliberately quote below the market to get borrowers in the door. Once inside, they are fair game for a variety of stratagems for raising the rate.

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Next week: Factors affecting the general level of interest rates.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com. Distributed by Inman News Features.

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