How Does Home Loan Interest Work?

When you take out a home loan, you owe the lender a sum of the principal, the interest, and other smaller fees. Charging interest and fees is how the lenders make money. Usually, the costs are standard, but the interest amount often varies from one borrower to another depending on various factors. So, how do lenders arrive at a specific figure in interest, and how do they calculate it?

This article explains the basics of a home loan interest rate, including the mortgage interest formula used to calculate interest.

How does home loan interest work?

The interest rate on your home loan is expressed as a percentage annual rate, calculated against the principal amount, which determines how much you’ll pay for the loan in a year. Since the annual amount can be significant, the lender breaks it down into smaller installments that you pay every month.

In determining the interest rate to attach to your home loan, lenders rely on factors like:

• The amount you’re borrowing: The more money you need, the higher the financial risk for the lender, and therefore, they charge a greater interest. So, seek to borrow less to qualify for lower interest rates. For example, you could save for a larger down payment and reduce the required loan amount.
• Prevailing market rates: The atmosphere in the lending market also significantly influences the interest rate you’re charged to your loan. If the market rates are high, you get a high interest rate, and vice versa.
• Repayment term: The longer the loan term you request, the higher the interest you’ll pay. The reason is that a shorter loan term does not pose as much of a financial risk to the lender as a longer loan term.
• Type of interest rate: There are generally two interest rates: fixed and variable (adjustable). Adjustable interest rates start out lower with a fixed initial rate, and after the specified period, the rate starts to climb higher to match market movements.
• Income and credit score: Higher credit scores qualify you for a low interest rate, while low credit scores show that the risk involved is high, and you are charged a higher interest rate. In addition, your income and debt situation also influence your interest rate in what is called the debt-to-income ratio. The ratio shows the portion of your income that goes towards paying debt.
• Closing costs: If the lender agrees to pay your closing costs, they do it in exchange for a higher interest rate.

How is the interest rate calculated?

To exhaustively answer the question ‘how does home loan interest work,’ we must then discuss how the interest is calculated. Lenders use a formula.

The mortgage interest formula used is: M = [ P . r (1 + r)n ] / [ (1 + r)n - 1 ]

Where:

• ‘M’ is the monthly mortgage payment
• ‘P’ is the principal amount
• ‘r’ is the interest rate attached
• ‘n’ is the number of payments in a year

Suppose you take out a $300,000 mortgage for 25 years with an amortized 6% annual interest rate. Since you will make monthly payments, the interest charged is divided by 12 and multiplied by the outstanding principal amount.

P = $300,000

r = 0.06 / 12 = 0.005

n = 25 × 12 = 300

Insert these figures into the mortgage interest formula M = [P. r (1 + r)n] / [(1 + r)n - 1] to find ‘M’.

M = [300,000 × 0.005 (1 + 0.005)300] / [(1 + 0.005)300 - 1]

M = $1,932.904

The mortgage you will pay per month is $1,932.91 (rounded up). In a year, you will pay $1,932.91 × 12, which is $23,194.92.

With a fixed-rate interest loan, the amount you pay monthly does not change. However, in theory, the amounts should be decreasing since the interest rate is multiplied by a reduced principal balance – however, home loan lenders use amortization to calculate your payments which keeps your payments consistent and predictable.

Amortization distributes the loan term’s interest so that your monthly payments are more interest and less of the principal amount in the early years. Towards the end of your loan term, the repayment switches – with more of your monthly payment going towards your outstanding balance, and only a tiny portion covers the interest.

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