How Do Interest Rates Work?

Mortgage lenders show their interest rates prominently, but they hardly ever illustrate exactly how these rates work. If you have a $200,000 mortgage for 30 years at, say, 7.5 percent interest, your monthly payment would be about $1,400. But the question is why the rate of interest if 7.5 percent? The suitable answer is that the annual rate is divided into the monthly interest rates and this monthly interest rate is applied to the monthly balance.

Now, let’s discuss the related factors with the mortgage interest rates from the lenders to find out how the rate of interest works.

Interest Rate Calculation

The interest rate for mortgages is calculated monthly. In order to achieve the monthly rate, you must divide the annual rate by 12 months. In the case of this mortgage, 7.5 divided by 12 comes out to a monthly rate of 0.625 percent. So, at every month you have to pay 0.625 percent of your main balance.

For the first month, consider your principal balance $200,000. Applying a monthly rate of 0.625 % on that, the payment for the first month becomes $1,250. Along with this interest amount, you also need to pay off a little of the principal too, for the first month. For the next month the interest become a bit less as the principal has become smaller.

Understanding the Interest Rate Formula

Banks use a formula that is known as ‘amortization formula’. This formula is used to generate a schedule of payments so the total payable amount for every month becomes the same. For the above loan amount, the monthly payable amount will be $1,398.43. This amount consists of two parts, they are: $1,250 as interest and $148.43 as principal. In the second month, the principal is now down to $199,851.57. Multiply that by the monthly rate of 0.625 percent, and you get an interest charge of $1,249.07. You’ll also pay $149.36 in principal, for a total payment of $1,398.43. Clearly, the amount is as same as the first month. And this amount continues for the rest of the months too. For each month interest become smaller and the principal payable amount becomes larger to attain a constant monthly premium.

Most Common Types of Interest Rates

These calculations show how fixed rate mortgages work. An adjustable rate mortgage or AMR almost works in the same way. The main difference between a fixed rate mortgage and an ARM is the ARM interest rate will adjust with the market. When the interest rate of AMR for the each month goes up or down, the rate calculates accordingly to keep a fixed monthly premium that you have to pay for each month.

Interest Rate VS APR

There are two different rates on which the mortgages are advertised. The first one is called ‘interest rate’ which is used to calculate the monthly payable amount as described above. The other interest rate is called ‘annual percentage rate’ or APR. There are some costs beyond the interest that you have to pay for the each and every loan. These are: origination fees, application fees, etc. APR must be applied by law from the end of the mortgage lender.


Review the different scenarios that might help you to better understand the total cost of the mortgage before moving forward with the loan. Through the process shown above you can calculate your interest and monthly payable amount for each month based on your principal. Don’t forget about the mortgage lenders that can help you better understand your interest rate options. These resources are easily available and can be very helpful in explaining what is best for your situation.