What is Mortgage Interest?

REVIEWED BY JAMES GHEEN | PUBLISHED ON AUG 30, 2019 | 8 MIN READ

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Mortgage interest is the reimbursement a borrower pays to his lender for the money used to purchase a property. This is the percentage that is charged on a mortgage loan that has to be paid in addition to the principal amount. Your mortgage interest rate indicates the annual cost to borrow money from a lender. For example, a 6% mortgage rate means you will pay 6% of your total loan balance in interest each year.

In this article we will cover the following topics:

The Interest Rate Could be Either Adjustable or Fixed.
How Mortgage Interest Rates are Determined?
Home Equity Loan

The interest rate could be either adjustable or fixed.

The adjustable-rate mortgage basically is a type of mortgage loan that you need to understand in order to answer the question, what is the mortgage interest rate and how lenders deduct the interest? It has interest rates which are adjusted based on the fluctuations in an associated periodic index. This type of loan can be offered at the lenders’ standard base rate. The index rate can be changed at the lender’s discretion in the case that the lender has offered no specific link to the underlying market. Adjustable-rate usually transfers part of your interest from the lender to you, the borrower. These types of loans are mostly used if the unpredictable interest rate makes fixed rate loans hard to attain.

An Adjustable-rate mortgage, like any other mortgage types, allows the borrower to choose to prepay the capital early with no penalty. Essentially, early payments of the principal reduce the total interest you pay. However, it won’t shorten the duration required to pay off your loan. Upon every recasting, your new and fully-indexed interest rate will then be applied to the rest of the principal to end as scheduled.

In December 1995, a study done by the government found out that over 50% of all Adjustable Rate Mortgages in the US have an error in terms of the variable interest rate charged to the borrower. This study estimated that the total interest amount overcharged to homeowners was over $8 billion. The lack of computer programs, poor completion of documents, as well as calculation errors are the main causes of interest rate overcharge.

A fixed-rate mortgage, on the other hand, is a type of mortgage loan that has a standard deduction rate. They are usually offered as amortized loans with payments that are made in installments. Contrary to the adjustable-rate mortgage, the fixed-rate mortgage loans bear the varying risk to both the lender and borrowers. These risks are usually centered on the interest rate environment. In times of rising rates, the interest rate risk for the lenders is higher and that of the borrower is lower since buyers typically seek to lock in lower rates of interest to save on the amount of interest paid overtime. This is also a major factor to understand if you want to understand what is the mortgage interest rate.

How Mortgage Interest Rates Are Determined?

Mortgage interest rates vary depending on larger investment activities and economic factors. The secondary market does play a vital role

Mortgage rates decrease when:

  • The stock market falters
  • There are insecurities or dips in the foreign market
  • Inflation rate slows
  • Jobs decrease or unemployment decreases

Mortgage rates on the other hand increase when:

  • The stock market is strong
  • The foreign market is strong and stable
  • Jobs are increasing

If the economy, foreign market, and stock market are strong, investors will require higher interest rates to get their money back.

Home Equity Loans

As we seek to answer the question of what is mortgage interest, we should consider understanding these types of mortgage loans. A home equity loan is consumer debt. This offers a potential or current homeowner the luxury of owning a home by borrowing against the equity. The home equity debt amount is essentially based on the exact difference between the home owner’s mortgage balance due and the current market value.

Your equity in the home will usually be the collateral for the lender. The amount the homeowner can borrow depends on a combined loan-to-value ratio of about 90% of your home’s appraised value. The rate of the interest charged and the amount of the loan will also be determined by the borrower’s payment history and their credit score at large. Traditional home equity home does have a repayment term similar to any other conventional mortgages. The buyer will be required to make fixed payments that cover both the interest and principal.

Home equity loans gained its renown after the Tax reform act of 1986. This act provided a means for borrowers to get around a major provision- doing away with the deduction for the interests on most customer purchases. Interest in the service of residence-based debt is one of the major exceptions the act left in place.

There are two varieties of home equity loans. These are:

  • Fixed-rate loans
  • Home equity lines of credit

The fixed-rate loans offer a lump-sum, single reimbursement to the borrower, which gets repaid in 5-15 years at an agreed interest rate. Interest paid and the payment of the principal remain fixed throughout the lifespan of the loan.

Home equity loans just like any other loan have its pros & cons that a borrower should keep in mind. Some of the advantages of home equity loans are:

  • Home equity loans can be a very valuable tool for responsible borrowers; it provides an easy source of cash. If you are looking to buy a home and you’ve got a reliable and steady source of taxable income, and you are sure that you can repay the loan over time, it’s a logical choice to take a home equity loan due to its low-interest rates and possible tax reduction for the tax year.
  • It’s secured debt- the lender does a credit check and directs your home appraisal to check your credibility as well as the combined loan-to-value ratio making it quite simple for most borrowers since you can only get what you are capable of paying back. This is a loan secured.
  • The interest loan rate on your home equity loan is way lower than the interest loan rate on credit cards as well as other credit loans although it is higher than the first mortgage. This is the prime reason customers borrow against their home value through a fixed-rate home equity loan.
  • These loans are the best choice if you know for sure what you’ll use the money for and how much you need. You will be guaranteed a specific amount which you will receive fully at closing. These types of loan are usually preferred for expensive and larger goals like remodeling or even debt consolidation.

There are downsides you should keep in mind, though. They are as follows:

  • They can be too risky- borrowers should be aware of the risks associated with these types of loans. The major issue with home equity loan is that it may sound like an all-too-easy way for borrowers who may have fallen into the perpetual cycle of spending money, borrowing, then spending and going deeper in debt. This case is unfortunately so common that lenders refer to is as reloading– the process of taking a loan to repay another loan.
  • Reloading causes an undesirable debt cycle which often compels a borrower to depend on these loans and offering 125% if equity on the borrowers’ home. This type of loans usually comes with a much higher fee simply because the borrower took out more than the house’s worth. The loan, therefore, cannot be entirely secured by the collateral. Furthermore, the buyer should be aware that the interest paid on the part of the home equity loan that is beyond the value of the loan is definitely not tax-deductible—in case you’re thinking about the tax deduction.
  • If you’re looking to get a home loan, it’s tempting to borrow more than what you initially need. This because you get the payout just once, then you are unsure if you’ll qualify to get another one later on.
  • If you’re thinking of getting a loan that’s worth more than the value of your home, it may be time to get a reality check. Otherwise, it could only lead you to huge financial distress.

Before taking this major step of taking any mortgage loan, make sure to understand the terms and conditions in place and understand what is mortgage interest and how everything, including the mortgage interest deduction, is calculated before your home purchase.

Bibliography

  1. Wiedemer, John P, Real Estate Finance, 8th Edition, pp 99–105
  2. ^ The Definition of a Variable-Rate Mortgage
  3. ^ Mishler, Lon; Cole, Robert E. (1995). Consumer and business credit management. Homewood: Irwin. pp. 132–133. ISBN 0-256-13948-2.
  4. ^ Jump up to a b c d e f g International Monetary Fund (2004). World Economic Outlook: September 2004: The Global Demographic Transition. pp. 81–83. ISBN 978-1-58906-406-5.
  5. ^ Jump up to a b Fabozzi, Frank J. (ed), Handbook of Mortgage-Backed Securities, 6th Edition, pp 259–260

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