Interest Rates
Interest rate is the percentage fee mortgage lenders charge over and above the amount loaned to the borrower. Interest compensates the lender for both time value of money and risk of default. Interest is most commonly paid and demanded in monetary form. However it is not uncommon for borrowers to pay and mortgage lenders to accept interest payments in other terms of other assets such as shares etc. Interest is a very common component of our financial system and is charged on other instruments apart from mortgage loans. Some of these instruments include financial and operating leases, corporate and sovereign bonds, savings and term deposit accounts etc. For asset backed instruments, interest is charged on the value of assets in much the same way as it is charged on money. Interest can also be perceived as an incentive for the lender in exchange of giving up useful investments that have been foregone for this loan. Mortgage loans are advanced to the borrower as an alternative of lenders utilizing them for consumption or investment elsewhere. The borrower has an advantage as he uses the asset immediately whereas the lender has to postpone his immediate consumption. Interest is a reward paid by the borrower for postponing immediate consumption. The amount (or asset) lent is known as the principal amount or asset. The principal asset is in the custody of the borrower on credit. Interest is thus thought to be the reward for risk undertaken to provide funds or the asset to a third party. It is not price of the money. Percentage of the principal that is paid as charge over a specific period is called the interest rate.
Interest rates on home mortgages can and should not be ignored as mortgage interest is the primary factor deciding if people can afford homes and at what cost. Small variations in interest rates can have a profound impact on the purchasing power and overall standard of living and financial condition of people. However interest rate is an essential component of our economy as most people accumulate wealth by owning a home. Interest payments often exceed amount of the mortgage loan over the life of the mortgage. A distinct advantage of interest is that interest paid is tax deductible and can be subtracted from the income on which taxes are to be paid. Interest rate and monthly payments for a fixed rate mortgage remain uniform throughout the life of the mortgage. Initially a very small component of the monthly payment comprises of the principal amount and the major chunk is composed of interest. Consequently most of the monthly payments in early years are tax deductible. Whereas in later years very little of the monthly payments are cash deductible because of the smaller component of interest and large component of principal amount. Many homeowners find monthly payments within their means in later years because of increments in salaries and inflation that contribute to lessen the burden of fixed monthly payments.
Refinancing is strongly recommended by experts if the current mortgage interest rates are lower than the interest rate applied to your mortgage. Although it may include various costs such as legal fees and closing costs it may still be a lucrative option if interest rates and experienced a substantial decline. Experts propose refinancing only when the current interest rate is at least two points lower than what you are actually paying. Refinancing also demands that you stay in the house for a long time i.e. at least five years. If you move out of the house in less than this time given it may be difficult to gain the benefits for which you refinanced the mortgage loan keeping in view the closing costs. An adjustable rate mortgage provides you the option of a fluctuating interest rate that is tied to an actual market interest rate. Adjustable rate mortgage loans usually have a lower initial interest rate as compared to the fixed rate mortgage. However interest rate in the adjustable rate mortgage is adjusted occasionally depending on changes in the market interest rate. Most adjustable rate mortgage loans have a floor and ceiling as to how much it can increase and decrease at maximum. Some adjustable rate mortgage loans restrict percent increase in monthly payment as a result of the periodic adjustment in interest rates. Interest rate is normally determined by the demand and supply mechanism within the credit market.
There are a number of players who impact interest rates by their interaction in the credit market. Individual savers and borrowers are not the only ones effecting the demand and supply of credit to the economy. Businesses, government and foreign organizations may also affect interest rates by increasing or decreasing demand and supply of the credit in the economy. Actions of the above mentioned parties determine actual interest rates. If all other factors are kept constant an increase in the demand for credit would raise interest rates and vice versa. Similarly if all other factors are kept constant an increase in the supply of credit would decrease interest rates and vice versa. Inflation is one the main causes behind the existence of the interest. Lenders want to make sure that their funds do not erode in value which is exactly what happens in times of inflation. Interest is thought to compensate them for this decrease in value of their money. Consequently interest rates are high inflationary periods and are lower people in deflationary periods. Purchase of homes may increase demand for the other goods such as furniture and home appliances that contribute to boosting economic growth. Low interest rates mean that customers are spending less and less on interest cost leaving a major chunk of their income to be spent on goods and services. Thus it is vital to understand how interest rates work and their importance in today’s economy. This would help you make a better decision when you take a mortgage loan for your own home!