How Are Interest Rates Calculated for Home Loans?
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Term of Loan
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Interest rates are calculated for home loans based on the term or length of the mortgage. Typical terms for home loans are 10, 15 or 30 years. Other terms are also available, but less common. One less common term is the five-year balloon mortgage. The payments are figured as if you financed the loan for 30 years, making the monthly payments as small as possible. However, the balance is due in full after just five years. Most home buyers must refinance their home loan at the end of the five-year balloon mortgage. Home mortgage interest rates may be at least one-quarter to one-half of a percentage higher for a 30-year home loan compared to a 15-year home loan. Of course, the differences between the 15-year and 30-year interest rates increase as home lending rates rise.
Fixed or Variable
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Buyers can choose between fixed and variable interest rates on home loans. Initially, the variable interest rates offered to home buyers are lower than the fixed rates offered, making variable rates seem more desirable. Variable rates seem better because the home buyer's monthly payment can be significantly lower depending on the size of the mortgage. The typical historic trend has been for variable rates to rise over the years of a home mortgage. As the interest rates rise, so do the monthly house payments that the homeowner must make. Variable rates may be equal to the prime lending rate set by the Department of Treasury. To avoid an unexpected change in monthly house payments, many home buyers choose fixed interest rates. Fixed interest rates may be at least one full percentage point higher than variable rates to offer lenders some initiative to lock in an interest rate for an extended period.
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Your Credit History and Stated Interest Rates
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While interest rates on home loans are usually quoted in terms of simple interest, it is more common for lenders to compound interest. Therefore, when financing a home the lender usually gives the home buyer a disclosure about the stated interest rate. This number is slightly higher than the interest rate quoted and is calculated by compounding the interest on the home loan.
A person may apply directly to a bank for a home loan. This is usually referred to as conventional financing. These home loans usually require a down payment and an established excellent credit history. Other home loans are offered through FHA (Federal Housing Act) and are backed or insured by the government. These loans have strict financing guidelines about the condition of the property and maximum purchase price. These interest rates are calculated slightly higher to take into account the higher risk involved in helping buyers without established credit or with less than excellent credit to purchase a home.
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