Most of us have at least one mortgage these days, but there is so much
confusion over the interest.  It seems like by the time you’ve paid off
your mortgage the interest costs more than your home.  I would love to
know how the interest is calculated and how it can end up being way
more than the home.  Also what is the difference between your APR and your
interest rate.  Please help.
Jennifer in NC

Like so many people, Jennifer was surprised when she got past the ‘easy
monthly payment’ and started learning about mortgages. Let’s see if we
can’t help her to understand the basics of interest and APR (annual
percentage rate).

We’ll start with definitions. According to Investorwords.com an
interest rate is “A rate which is charged or paid for the use of money. An
interest rate is often expressed as an annual percentage of the principal.
It is calculated by dividing the amount of interest by the amount of
principal.”

They define APR as “the yearly cost of a mortgage, including interest,
mortgage insurance, and the origination fee (points), expressed as a
percentage.”

BusinessDictionary.com defines APR a little differently. “Standardized
method of quoting the effective interest rate (actual cost of credit)
on consumer loans, specially where interest is computed on monthly or
other non-annual basis. An APR includes all fees (except penalties), and
takes into account the continual reduction of principal amount through
amortization.”

Let’s first examine the definition for interest rate. Simply put, it’s
a rate that the borrower pays for using the lender’s money. Just like
you would pay to rent a car or a punch bowl for a wedding, you pay to
rent money.

Interest is typically stated in a percent of the amount owed that’s due
every year of the loan. A real simple example would be if I borrowed
$100 from you and agreed to pay you back one year from today along with
8% interest. When the year was up I’d need to give you $108 (the
original $100 plus $8 interest).

Next we’ll examine how the frequency of compounding effects the real
cost of borrowing. In our example the interest was compounded once a
year. But what would happen if we compounded it twice a year?  At the end
of the year I would need to pay you $108.16.

Why sixteen cents more than the original example? I’d still have to pay
back the same $100 principal. But because the interest is compounded
twice each year, we’d need to calculate and add two separate interest
payments. For the first six months I’d owe $4 ($100 principal times 8%
annual interest divided by two - i.e. 4%).

But for the next six months I’d owe $4.16. Because interest was owed
(and unpaid) after the first six months, the principal amount was
increased by $4 to $104. And 4% (half of 8%) of $104 is $4.16. So over the
entire year I’d owe $8.16 for interest ($4 first six months plus $4.16 for
the second six months).

If we were to compound daily, the total due at the end of a year would
be $108.33. So even though the interest rate stays the same (8%) the
amount that you’ll pay could vary by $0.33 depending on how often
interest is compounded. Not a tremendous amount, but it does add up when
you’re borrowing hundreds of thousands of dollars.

The APR will include any additional costs caused by frequent
compounding. When it’s used in a mortgage situation it also includes mortgage
insurance and any ‘points’ that came with the mortgage. For most of us
it’s almost impossible to calculate how much we’d owe on a mortgage with
all the different variables involved. The APR does that for us. We can
take two mortgages and compare the APR on each. You can also use the APR
to compare non-mortgage consumer loans.

Next let’s look at all the interest that Jennifer expects to pay. She’s
right. A traditional 30-year mortgage earns a lot of interest for the
lender. To illustrate we turned to a mortgage calculator on
Bankrate.com. For a 30-year, $200,000 mortgage at 6% you’ll pay $231,676 in
interest over the life of the mortgage. Just as Jennifer said, you’ll actually
be paying more in interest than you originally borrowed.

One solution for Jennifer is to go to a shorter mortgage. A 15-year
mortgage (the same $200,000 at 6%) would require $103,788 in interest
payments. That’s a huge difference. The downside is that Jennifer will need
to handle a higher monthly payment ($1,687 vs. $1,199).

The higher payments might scare Jennifer. But she still has an option
that will reduce interest expense. As long as her mortgage allows for
prepayments, she can pay more than the regular payment each month. Have
the lender apply the extra money to a reduction in principal. Depending
on how much she prepays each month, it could be just a effective as a
15-year mortgage in reducing the amount of interest paid.

Hopefully Jennifer will find both the home and the mortgage that she
loves and can afford.
__________

Gary Foreman is a former financial planner who currently edits The
Dollar Stretcher.com website and newsletters. You’ll find hundreds of ways
to stretch your day and your dollar. Visit today!