How Do Banks Calculate Mortgage Interest?

If math is not your thing, your head might spin when thinking about mortgage calculations. If you plan on cutting down the length of your mortgage and reducing the amount of interest you accrue through additional mortgage payments, understanding how your interest is calculated will help you to develop the right strategy.

TL;DR (Too Long; Didn't Read)

Banks use the federal funds rate, your credit risk and the type of mortgage you are applying for when determining your interest rate.

Setting the Rate

Lenders use three primary pieces of criteria when setting a mortgage rate. The federal funds rate is set by the Federal Reserve, and it is usually the basis for the prime rate used by most financial institutions to set their general interest rate on mortgages and other types of loans and revolving credit.

Your predicted ability to repay the loan based on past credit history also plays a part. If you have dings on your credit report for missed or late payments on past loans, expect to pay a higher interest rate on your mortgage than someone with a clean report and proven credit history.

Lenders also take the type of mortgage into consideration when setting your loan rate. Mortgages that put the bank at higher risk, like a fixed-rate mortgage instead of an adjustable-rate mortgage, normally come with slightly higher interest rates.

Understanding How Amortization Works

Amortization is the method that lenders use to calculate mortgage payments. This technique allows lenders to determine how much of each of your payments will apply towards interest and how much to the original loan balance. Since your loan balance changes each time any money is applied towards principal, and the interest rate may change if you have an adjustable-rate mortgage, or ARM, lenders redo the calculation after each payment you make. The one rule of thumb is that your total payment never changes unless you have an ARM, but the amount applied towards principal and interest changes with each payment.

Mortgage Interest Calculations

Calculating a mortgage payment is a fairly complicated algorithm, but determining your interest due is a fairly simple matter. To calculate the amount of interest in your first payment, divide your interest rate by the number of payments you make each year and then multiply that by the amount of principal you owe.

If you have a $100,000 mortgage at a 6 percent interest rate and you make payments each month, you would divide 6 percent by 12 months to come up with 0.5 percent. Multiply your $100,000 loan balance by 0.5 percent to come up with your accrued interest for the month, or $500. If you have a similar mortgage but are on a biweekly payment schedule, repeat the above calculation using 26 payments instead of 12.

How Negative Amortization Happens

With a traditional amortization and payment schedule, the amount of each payment applied toward principal grows while the amount of accrued interest decreases over time. Some mortgages, like deferred payment option ARMs, have a very different scenario.

While the interest is calculated in the same manner as any other mortgage, the lender defers a portion of the accrued interest in each payment. Instead of becoming due and payable, the deferred portion is tacked onto your original loan balance so that your balance becomes more instead of less with each payment, accruing more and more interest over the life of the loan.

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