Home Mortgages & Types of Compound Interest
Mortgages use interest rates to determine how much borrowers have to pay lenders above the principal. This represents how much profit the lenders earn. Some types of interest are simple, or are only calculated at intervals, with rates applying only to the principal. Compounded interest may only be calculated at set times, but it tends to accrue more frequently and applies to both the interest owed and the principal. This means borrowers have to pay more interest in total.
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Payment Process
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On most mortgages interest will compound daily. Borrowers do not pay every day, but they pay monthly installments that contribute to both the interest that is accruing and the total principal amount. In the beginning of the mortgage most of the payment amount goes toward the interest, which because of the high principal is very high itself. As the principal is paid down, the interest decreases and more of the monthly payment goes toward the principal until the loan is fully paid off.
Variable
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There are two general types of compound interest in mortgages, variable and fixed. Variable compound rates still accrue, usually by the day, but the rate itself can change. Lenders base the rate on an index that takes into account economic conditions and interest rates as a whole. This often means that rates can rise over time, starting low but ending high and creating more interest for the borrower. Depending on the mortgage, lenders can change the rate monthly, quarterly or annually, but only within limits.
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Fixed Rate
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Fixed-rate compound interest is a more stable alternative. In a fixed-rate mortgage, the rate itself does not change. Lenders set it at the beginning of the mortgage, and every time it is applied it stays the same throughout the life of the loan. Borrowers must make higher payments during the beginning of the loan, but the payments do not change based on the interest rate, and by the end of the loan they are making lower payments than would be required with a variable rate loan.
Discount Points
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Discount points are a feature lenders offer to change a fixed compound interest rate. Points refers to percentage points of the total principal. Lenders allow borrowers to pay points in exchange for a reduced interest rate. For example, if the principal is $100,000, then lenders may allow a borrower to pay three points, or $3,000 in loan fees, for a reduction in the interest rate from 5.5 percent to 5.0 percent. There are many different possible combinations of rates and points.
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