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Interest and Risk

Interest is what makes it costly to borrow money. It’s not unheard of for a borrower to pay pack twice what they were originally loaned, when all is said and done. It’s vital to understand how the term of your mortgage affects how much interest you will pay, and how interest rates are linked to the concept of financial risk.

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Principal, Term and Rate

The amount of interest you pay on your mortgage depends on three things:

  1. The loan’s principal, which is the original amount of the mortgage.
  2. The loan’s term, which is how many years you take to pay the mortgage off.
  3. The loan’s interest rate, which is expressed as a percentage.

The longer the term, the more interest you have to pay. For example, say you took out a $100,000 mortgage and your interest rate was 7 percent. Look at how the term affects your monthly payment and total cost:

Example – Principal: $100,000 | Interest rate: 7% Term: 30 years → Monthly Payment: $665 → Total Cost: $239,509 Term: 15 years → Monthly Payment: $899 → Total Cost: $161,789

With a shorter term, your monthly payment is higher, but it saves you a great deal of money in the long run, and you get to own your home free and clear that much sooner. Common mortgage terms are 15 years and 30 years, but other options are available as well.

Wouldn’t it be nice, though, if there was a way to lower your total cost and your monthly payment at the same time? Therein lies the power of the interest rate. Let’s look at our example again and see what happens when your interest rate is 5 percent instead of 7 percent:

Example – Principal: $100,000 | Interest Rate: 5% Term: 30 years → Monthly Payment: $537 → Total Cost: $193,256 Term: 15 years → Monthly Payment: $791 → Total Cost: $142,343

What a difference two percentage points make! You get the same $100,000 loan as before, but you can have the lowest monthly payment and still save a substantial amount of money over the whole life of the loan, or you can pay the lowest total cost and still save on every monthly payment.

What makes the interest rate high or low?First and foremost, it depends on how the economy is doing overall, as well as the local market in your region. Beyond that, it’s explained by the concept of risk.

Less money spent on interest means more money to spend on your family.

Risk

Lending money means taking a risk. For a mortgage lender, the risk is the borrower will one day stop paying their mortgage, which is called defaulting. When this happens, the lender can foreclose on the home, but there is no guarantee the lender will be able to recover their investment of money. Foreclosures are bad for both borrowers and lenders.

What Makes a Mortgage Safer?

If the mortgage looks like a relatively safe investment for the lender, they can set a lower rate to make their offer more competitive.

  • A shorter term: It’s good for a lender to get the return on their investment sooner rather than later.
  • Good credit: If you have a history of being responsible with your finances, lenders will be more willing to work with you.
  • A higher down payment: If you are willing to invest more of your own savings upfront, it shows you will be committed to paying your mortgage.
  • Discount points: You can pay money to the lender up front in exchange for them charging less interest in the long run.
  • Backing from a government program: Organizations like the VA and the FHA make mortgages a safer investment for lenders.

What Makes a Mortgage Riskier?

If a lender sees a particular mortgage as a higher risk, they will set a higher rate to compensate for it.

  • Waiving upfront costs: In some cases, it is possible to get a mortgage without paying any upfront fees, but this shifts more of the initial financial burden to the lender.
  • Purchasing a property as an investment rather than a primary residence: Lenders perceive that paying off an investment property will be less of a priority for you than paying for your own living expenses.
  • Cashing-out equity: Refinancing to convert some of the equity in your home to cash is considered riskier than getting a conventional mortgage.
View Sources
  1. Consumer Financial Protection Bureau. (2015, January 20). 7 Factors That Determine Your Mortgage Interest Rate. Retrieved from http://www.consumerfinance.gov/about-us/blog/7-factors-that-determine-your-mortgage-interest-rate/
  2. Lewis, H. (2016, June 13). How Your Mortgage Interest Rate Is Set and by Whom. Retrieved from http://www.bankrate.com/finance/mortgages/how-lenders-set-rates.aspx
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