Mortgage Interest, Points, and Annual Percentage Rates

Perhaps one of the most complicated aspects of a mortgage loan is that of the accompanying interest payments. True of any type of loan, the bank or financial lender charges a fee for the use of the moneys loaned.

Within the mortgage finance industry, it is more common that this fee be referred to as the interest.

A. Interest: Definitions

Formal definitions for interest include:

• The amount paid by a borrower to a lender for the use of the lender's money for a certain period of time.
• Lenders make money from interest, borrowers pay it.
• The charge for the privilege of borrowing money is typically expressed as an annual percentage rate.

B. Interest Rates: Calculations

To calculate a client's simple interest, one need merely employ the following formula:

I = Prt (interest = principal x rate (decimal) x time).

Yet, while the concept of interest and its applications to mortgages may appear relatively straightforward, the idea becomes more complex when you take into account the ways in which interest rates (based upon market indexes constantly in a state of flux) are determined.

When looking to establish an interest rate for a new mortgage loan, the banker-broker takes into account three ideas:

1) Federal Reserve Discount Interest Rate. For the most part, because banks and ancillary lending institutions borrow money at a discount rate from the Federal Reserve, the rate has a direct effect upon what is known as the current Prime Interest Rate.

The Prime Interest Rate then is the interest rate on short term loans charged by banks to commercial clients with high credit ratings. Typically speaking, individuals tend to pay a rate based upon the Prime Rate plus an amount for interest.

2) Individual borrower's FICO score and credit report. The FICO score, a method of determining the likelihood of credit users paying their bills, synthesizes a borrower's credit history into a single number. Companies which collect credit related information are referred to as Consumer Reporting Agencies (CRAs).

3) Specialized Lender Business Practices. As a banker-broker, it is important to understand that loans differ based upon the institute of origin. Hence, some financial lenders are able to lower rates and get more attractive terms for their clients where other borrowers do not get such attractive terms due to their non-competitive nature.

C. Interest Rates: Calculations on Simple (Fixed Rate) Mortgages

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To ascertain the regular payments that a borrower of a fixed rate mortgage will need to make, it is the practice of the banker-broker to determine several things upfront:

• Scheduling of regularly monthly payments. Will the borrower make them on the 1st, 15th or 30th each month
• Assessment of annual interest rates. The fixed rate upon which the loan will be determined will be a mixture of the previously listed factors.

Once the previously stated items are determined, it is possible to calculate a client's regular mortgage payments. For example, take an individual's principal loan balance of \$250,000 and multiply it by 6% the annual interest rate. The annual interest then amounts to \$15,000. Divide the annual interest by 12 months to arrive at the monthly interest figure, that of \$1250.

If the client's regular monthly payments are \$1,499.88 and the loan balance is \$250,000 at an annual 6 percent rate amortized* for 30 years to arrive at the principal portion of the monthly payment you will subtract the monthly interest (\$1250) from the principal and interest payment (\$1499.88), the result being \$249.88, the portion of the monthly payment that goes towards the principal amount.

*Amortized is a term used in association with a long term loan, where the borrower makes monthly payments, part of which covers the interest on the loan and part of which go towards repaying the principal.

If you then subtract, the \$249.88 (portion that is paid toward the principal balance of \$250,000, you arrive at \$249,750.12 the remaining unpaid principal balance after the first monthly payment.

With each consecutive payment, the client's unpaid principal balance will drop by a slightly higher principal reduction amount as compared with the previous month. This is because the principal portion of the monthly payment increases each month while the interest portion decreases.

Note: In the United States, interest is paid in arrears. This means that the client's monthly principal and interest payment will go towards paying the interest for the 30-day period immediately preceding the payment's due date, for example, the month of October for payments due on November 1.

D. Points

Often linked to the interest rate, points, also known as discount points, are fees paid to the banker-broker to cover costs associated with the loan. Paid up front, points help to reduce interest rate charges.

By pre-paying the interest on the loan in one fell swoop, the borrowers are able to lower their regular monthly payments. Each point is the equivalent of 1% of the loan balance. For example, if your loan amount is \$250,000, each point equals \$2500.

As is typical of points, the more a borrower pays, the lower their rates. There is, however, no universal formula to which all banker-brokers adhere. Hence, not only do the market rates on points change daily, but all lenders employ a different methodology for computing and applying them to a client's mortgage.

E. Annual Percentage Rate (APR)

While in the same general camp as interest rates, the Annual Percentage Rate differs in that it encompasses interest rates along with any additional costs or prepaid finance charges (prepaid interest, private mortgage insurance, closing fees, points, and so on)

Expressed as a yearly rate, the APR tends to be higher than the interest rate for it includes all of the aforementioned fees and charges. In a nutshell, the APR represents the total cost of the loan on an annual basis.

What tends to confuse consumers is that the interest rate alone does not sufficiently cover all of the accompanying charges and fees associated with the loan. For this reason, some refer to the APR (which may be stated as an interest rate) as the true rate for it more accurately depicts the full array of costs a borrower will need to pay.

F. Truth in Lending

To ensure APRs are both readily visible to consumers and stated truthfully, the Federal Reserve has enforced specific stipulations as to the ways in which lenders need to disclose financial lending information to consumers.

In particular, under the Federal Reserve's Truth in Lending (TIL) Regulation Z legislation, uniform methods have been prescribed to lenders with respect to the computation of credit costs, disclosures of credit terms, and resolutions of certain types of credit accounts.

And, in 2008, an amendment was added to the TIL regulation addressing the need to protect consumers from unfair or misleading home mortgage lending and advertising practices.

Essentially, the TIL regulation has sought to eliminate deceptive practices while calling for increased transparency within the mortgage lending industry and disclosure prior to a consumer's conclusion of a loan transaction.

According to former Federal Reserve Chairman Ben S. Bernanke, "Our goal is to promote responsible mortgage lending, for the benefit of individual consumers and the economy. We want consumers to make decisions about home mortgage options confidently, with assurance that unscrupulous home mortgage practices will not be tolerated."