The largest financial transaction most homeowners undertake is their home mortgage, yet very few fully understand how mortgages are priced. The main component of the price is the mortgage interest rate, and it is the only component borrowers have to pay from the day their loan is disbursed to the day it is fully repaid.
DEFINITION OF INTEREST RATE
An interest rate is the price of money, and a home mortgage interest rate is the price of money loaned against the security of a specific home. The interest rate is used to calculate the interest payment the borrower owes the lender.
The rates quoted by lenders are annual rates. On most home mortgages, the interest payment is calculated monthly. Hence, the rate is divided by 12 before calculating the payment.
Consider a 6 percent rate on a $100,000 loan. In decimals, 6 percent is .06, and when divided by 12 it is .005. Multiply .005 times $100,000 and you get $500 as the monthly interest payment.
INTEREST AND OTHER LOAN CHARGES
Interest is only one component of the cost of a mortgage to the borrower. They also pay two kinds of upfront fees, one stated in dollars that cover the costs of specific services such as title insurance, and one stated as a percent of the loan amount which is called “points.” And borrowers with small down payments also must pay a mortgage insurance premium which is paid over time as a component of the monthly mortgage payment.
INTEREST RATE AND THE APR
Whenever you see a mortgage interest rate, you are likely also to see an APR, which is almost always a little higher than the rate. The APR is the mortgage interest rate adjusted to include all the other loan charges cited in the paragraph above. The calculation assumes that the other charges are spread evenly over the life of the mortgage, which imparts a downward bias to the APR on any loan that will be fully repaid before term — which is most of them.
MONTHLY INTEREST ACCRUAL VERSUS DAILY ACCRUAL
The standard mortgage in the U.S. accrues interest monthly, meaning that the amount due the lender is calculated a month at a time. There are some mortgages, however, on which interest accrues daily. The annual rate, instead of being divided by 12 to calculate monthly interest is divided by 365 to calculate daily interest. These are called “simple interest mortgages,” I have discovered that borrowers who have one often do not know they have one until they discover that their loan balance isn’t declining the way it would on a monthly accrual mortgage. Simple interest mortgages are the source of a lot of trouble.
FIXED VERSUS ADJUSTABLE INTEREST RATES
A mortgage on which the interest rate is set for the life of the loan is called a fixed-rate mortgage, or FRM, while a mortgage on which the rate can change is an adjustable rate mortgage, or ARM. ARMs always have a fixed rate period at the beginning, which can range from six months to 10 years. The rate adjustment feature of an ARM makes it a lot more complicated than an FRM, which is why many borrowers won’t consider an ARM.
THE STRUCTURE OF MORTGAGE INTEREST RATES
On any given day, Jones may pay a higher mortgage interest rate than Smith for any of the following reasons:
–Jones paid a smaller origination fee, perhaps receiving a negative fee or rebate.
–Jones had a significantly lower credit score.
–Jones is borrowing on an investment property whereas Smith is borrowing on her primary residence.
–Jones’ property has four dwelling units whereas Smith’s is single family.
–Jones is taking “cash-out” of a refinance, whereas Smith isn’t.
–Jones needs a 60-day rate lock whereas Smith needs only 30 days.
–Jones wants to waive the obligation to maintain an escrow account whereas Smith doesn’t.
–Jones allows the loan officer to bamboozle him into accepting a higher rate, while Smith doesn’t.
All but the last item are legitimate in the sense that if you shop online at a competitive multilender site, such as mine, the prices will vary in the way indicated. The last item is needed to complete the list because many borrowers place themselves at the mercy of a single loan officer.
CHANGES IN MORTGAGE INTEREST RATES
Most new mortgages are sold in the secondary market soon after being closed, and the prices charged borrowers are always based on current secondary market prices. The usual practice is to reset all prices every morning based on the closing prices in the secondary market the night before. Call these the lender’s posted prices.
The posted price applies to potential borrowers who have been cleared to lock, which requires that their loan applications have been processed, and that the appraisals and all the required documentation have been completed. This typically takes several weeks on a refinance, longer on a house purchase transaction.
To potential borrowers in shopping mode, a lender’s posted price has limited significance, since it is not available to them and will disappear overnight. Posted prices communicated to shoppers orally by loan officers are particularly suspect, because some of them understate the price to induce the shopper to return, a practice called “low-balling.” The only safe way to shop posted prices is online at multilender web sites such as mine.
ABOUT THE WRITER
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.
©2016 Jack Guttentag
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