Valley Real Estate

Interest is the price of money, that is, someone else's money and your temporary use of it. When you take out a loan you usually pay it back in monthly installments. Each installment is composed of a principal portion (that portion that will go to pay off the amount of the original loan) and interest (the amount that the lender is charging you for the use of his money).

Without interest, there would be no incentive for anyone to give up access to his money so that others could use it. When you put money into a savings account at a bank the bank pays you for the use of your money. In turn, the bank uses your money to make loans to other folks. It is compensation to the lender for use of his money.

Interest is expressed as a percentage of an annual rate. Simply put, if you borrow $100 for one year, and the interest rate is 10%, then you will have to repay the original $100  - plus $10 in interest.

Because interest is expressed as a rate, it makes it easy to compare rates between different kinds of loans and between different lenders.  When you shop for a loan you look for the best combination of interest rate and terms.

From the lender’s point of view:

• Interest is a hedge against the effects of inflation, or rising prices. As prices rise, lenders (or savers) are repaid over time with dollars that are worth less than the dollars they lent. Interest is a replacement for the lost purchasing power of the lenders money.
• Interest is also an incentive for the lender to take the risk of making the loan in the first place. These risks include more inflation than the lender expected and the simple fact that the borrow may default and never repay the loan.
• For banks and other lending institutions, interest is the profit they need to run their business. It is competition among these institutions that keep the rates at comparable levels and in check.

From the borrower’s point of view:

• Individuals are willing to pay interest to borrow money in order to be able to spend now, rather than later, on cars and many other items
• Individuals are willing to pay interest in order to be able to afford a large purchase, such as a home, for which they don’t have enough funds of their own
• Businesses are willing to pay interest in order to borrow to invest in equipment, buildings, and inventories that will increase their profits
• Some borrowers are willing to pay interest on certain loans because of the associated tax advantages. Mortgage interest, for example, is tax deductible. That means that in calculating how much income tax you have to pay, you can subtract the mortgage interest that you pay from your income
• Banks are willing to pay interest on their customers’ deposits because they can lend the funds at higher interest rates and make a profit

We already said that one risk the lender must overcome is that of not being repaid. The greater the chance that you won’t be repaid, the higher the interest rate you will charge for taking the risk. However, if a loan involves little risk, you'll take a lower rate on a sure thing. For this reason, the government is usually able to borrow at lower rates than individuals.

Car loans rates are less than interest rates of credit cards. This is because the car is 'secured' by the lender as collateral. If you don't pay, the bank takes back the car. If you renege on a credit card debt there is nothing tangible the lender can use to replace your debt. The credit card debt is 'unsecured.' Interest rates, therefore are smaller on "secured" loans than on unsecured loans, because there is less risk.

Even secured loans will carry different rates depending on how likely the borrower will be to repay the loan. The overall assets and credit history of the borrow, tells the lender how risky it is to make the loan. The lender collects information on your overall wealth and income to determine if you are capable of repaying it. He also take a look at your credit history to determine if you have repaid your past obligations. Credit reporting companies rate the creditworthiness of individuals, business entities, and even countries. The more creditworthy you are, the less interest you'll pay, because you present less risk.

The longer the term of a loan, the more likely the lender is to desire access to the funds. So lenders typically have to be compensated with higher interest rates for parting with their funds for longer periods.

The longer the duration of a loan, the greater the uncertainty over whether the borrower will be able to repay the loan. So, lenders have to be compensated for the greater risk with higher interest rates on longer-term loans.

Inflation is a major factor determining the level of interest rates. The longer the duration of the loan, the greater the risk that inflation can accelerate, reducing the purchasing power of the loan repayment. So, rates generally are higher on long-term loans than on short-term loans, because people who lend for longer periods have to be compensated for the risk that inflation might accelerate during the longer periods.

If you receive interest income, you are more concerned with how much of the income you can keep than with how much the borrower pays. You are concerned with after-tax income -- that is, the interest you receive minus any taxes you have to pay on that interest.

Interest on some types of loans has some tax advantages. Interest on loans to state and local governments is exempt from the federal income tax, and interest on loans to the federal government (such as the interest you receive on U.S. Savings Bonds) is exempt from state and local income taxes. These tax advantages help governments borrow at lower interest rates than individuals or businesses.

When you put money into a bank account, you are allowing the bank to use the money. There are different types of bank accounts, though, and they pay different rates of interest. An account that allows you to write checks, for example, provides you with a benefit, so it pays a lower rate than a savings account, which does not offer this benefit.

If you agree to leave your funds in a savings account for a specified time – two years or five years, for example – you are providing the bank with some benefits. The bank knows for certain that it will keep your deposit, and it knows it can use the funds longer than if you had deposited them in, say, a checking account. In return, the bank will pay you a higher rate than on an account from which you can withdraw your funds at any time.

Suppose you lend to someone and suddenly you need the money back. It would be advantageous to you to be able to convert the loan into money quickly and without losing much of what you have lent. Loans that can be converted into money quickly and without a loss (either because you can demand that the borrower repay the loan at any time or because you can sell the loan to someone else) carry lower rates than other loans.

Two-thirds of U.S. households own their own homes (as opposed to renting), and most homeowners pay a mortgage. Thus, the level of mortgage rates determines how much all these homeowners have left to spend on other things. How much people can spend on other things, in turn, affects the overall economy.

Interest rates on home mortgages are important because mortgage interest is a major item in many people’s budgets. Even small changes in mortgage interest rates can have a large impact on how affordable it is to own a home. That’s important, because homeownership is the major way many families build up wealth.

The interest payments over the life of a mortgage often add up to more than the amount of the mortgage loan. For example, the interest payments on a 30-year, $100,000 mortgage at a 7% interest rate will add up to about $140,000 over the 30 years.

People who have mortgages may deduct the interest they pay from their income in calculating how much income tax they have to pay. That’s a significant benefit of owning a home.

The interest rate for a fixed-rate mortgage remains the same for the life of a mortgage, and the monthly payment also stays the same for the life of the mortgage.

For example, a 30-year, $100,000 mortgage at an interest rate of 7% requires a monthly payment of $665.30. Every month for 360 months, the payment of principal plus interest equals $665.30.

The vast majority of the monthly payment in the early years of the mortgage is for interest, and only a small amount reduces the principal, the amount of the original loan still owed. The opposite is true in the latter years of the mortgage.

Therefore, most of the monthly payment in the early years of the mortgage is income-tax-deductible, but very little of the payment in the later years is deductible. Usually, however, homeowners will find the payments more affordable in the latter years, because incomes generally rise, and inflation reduces the "real" burden of the fixed payment.

 

An adjustable-rate mortgage has an interest rate that moves up and down based on changes in some other rate, called the "index rate." A common index rate is the rate on a specified U.S. Treasury security.

An ARM typically has a lower initial interest rate than a fixed-rate mortgage, but the ARM rate is adjusted periodically (perhaps every year), based on changes in the index rate.

Many ARMs place a limit on how much the interest rate can rise in a single adjustment or over the life of the mortgage. Similarly, some ARMs limit how much the monthly payment can increase as a result of a periodic adjustment. That limits the risk that the borrower will be unable to make the payments, but a potential problem related to the payment cap is that of "negative amortization," or an increasing mortgage balance. That can happen if the payment cap does not allow the increase in the payment to cover the increase in the interest due each month.

An adjustable-rate mortgage has an interest rate that moves up and down based on changes in some other rate, called the "index rate." A common index rate is the rate on a specified U.S. Treasury security.

An ARM typically has a lower initial interest rate than a fixed-rate mortgage, but the ARM rate is adjusted periodically (perhaps every year), based on changes in the index rate.

Many ARMs place a limit on how much the interest rate can rise in a single adjustment or over the life of the mortgage. Similarly, some ARMs limit how much the monthly payment can increase as a result of a periodic adjustment. That limits the risk that the borrower will be unable to make the payments, but a potential problem related to the payment cap is that of "negative amortization," or an increasing mortgage balance. That can happen if the payment cap does not allow the increase in the payment to cover the increase in the interest due each month.