How Are Interest Rates Calculated?

Interest rates are primarily determined by the lender. In most cases, the lender will use a formula and take into account various factors to create a payment schedule outlining the amount of principal and interest rate to be paid monthly. This payment schedule and the interest rate to be paid by borrowers is presented as part of the loan package offered by the lender.

It is important to note that depending on the type of mortgage chosen by the borrower, the interest rate for a given loan may not be set in stone. There are two types of interest rates widely used in the mortgage market, fixed-rate and adjustable-rate. As the names suggest, the interest rate of a fixed-rate mortgage will not change throughout the life of the mortgage, whereas adjustable rates, starting from a low initial rate, shift over time. The adjustable rate will shift depending on external factors, such as the market index for interest rates.

When determining the interest rate charged to a borrower, the lender normally takes the following factors into consideration:

  • Mortgage Term. The shorter your mortgage term, the lower the total amount of interest you will have to pay to the lender, but the higher your monthly payments.

  • Credit Scores. The lender will assess your likelihood to default on repayment based on your credit history. This includes your credit cards, loans, and other payment history. The higher the credit score you have, the lower the interest rate you will be offered.

  • Down Payment. If you make a large down payment, lenders will give you a low interest rate. This is because a larger down payment means a lower level of risk for the lender. In practice, a down payment of 20% or more of the total purchase price will make you much more likely to get a lower interest rate.

  • Interest Rate Type. As mentioned above, two types of mortgages based on interest rate are a fixed rate mortgage and adjustable rate mortgage. Typically, an adjustable rate mortgage includes a lower initial interest rate than a fixed rate mortgage, though the adjustable rate may rise over time.

Tellus TIP:

As a borrower, you should pay careful attention to the factors which may influence the calculation of your interest rate. The list of factors provided here is objective. There are additional factors, including subjective factors related to your lender, that also will impact the level of interest rate you will have access to.