Interest Rate

Definition

An Interest Rate is the percentage of a sum of money charged for the use of borrowed funds. It can also represent the rate of return on an investment. Interest rates play a critical role in the real estate market as they affect mortgage payments, the cost of borrowing, and investment returns.

Examples

Mortgage Loan: A $250,000 mortgage loan is made at a 6% interest rate and 4 discount points. The contract interest rate is 6%, which determines the monthly payment. The effective interest rate, which incorporates the effects of the discount points, is 6.39%. This rate represents the lender’s actual return if the loan runs to maturity.
Savings Account: An individual deposits $10,000 in a savings account offering a 2% annual interest rate. At the end of the year, the account balance will have grown by $200 due to interest earned.

Frequently Asked Questions (FAQs)

What is the difference between nominal interest rate and effective interest rate?
- The nominal interest rate is the stated rate on a loan or investment, not taking compounding into account. The effective interest rate includes the impact of compounding within the loan or investment period.
How do interest rates affect mortgage payments?
- Higher interest rates increase monthly mortgage payments and the overall cost of the loan. Lower interest rates reduce monthly payments and the total interest paid over the loan term.
What are discount points?
- Discount points are upfront fees paid to the lender at closing in exchange for a reduced interest rate (often referred to as buying down the rate). One discount point typically equals 1% of the loan amount.
How are real estate investments influenced by interest rates?
- Interest rates impact the cost of financing real estate investments. Lower rates can make borrowing cheaper, boosting investments, while higher rates can increase costs, potentially reducing investment appeals.

Mortgage:
- A mortgage is a loan secured by the property being purchased. Mortgage terms typically include an interest rate, the loan amount, and the repayment schedule.
Amortization:
- Amortization is the process of gradually paying off a debt over a set period through regular payments. These payments cover both interest and principal repayment.
Fixed-Rate Mortgage:
- A fixed-rate mortgage features an interest rate that stays constant for the entire loan term, providing predictable monthly payments.
Adjustable-Rate Mortgage (ARM):
- An ARM has an interest rate that can change periodically based on the performance of a specific benchmark or index. These changes can affect monthly payments.

Online Resources

References

“Principles of Real Estate Practice” by David C. Ling and Wayne R. Archer

Suggested Books for Further Studies

“The Book on Rental Property Investing” by Brandon Turner
- This book dives into various aspects of real estate investing, including the impact of interest rates on real estate finance.
“Real Estate Investing: Market Analysis, Valuation Techniques, and Risk Management” by David M. Geltner
- It covers detailed insights into market analysis and valuation, with discussions on interest rates and their potential impacts.

Real Estate Basics: Interest Rate Fundamentals Quiz

### Does the effective interest rate take into account compounding interest? - [x] Yes, it does take into account compounding. - [ ] No, it doesn't account for compounding. - [ ] It only affects interest rates annually. - [ ] Only monthly compounding is considered. > **Explanation:** The effective interest rate includes the impact of compounding interest, making it a more accurate representation of the cost of borrowing compared to the nominal interest rate. ### What is one advantage of a fixed-rate mortgage for a borrower? - [ ] The interest rates always decrease over time. - [ ] The interest rates are higher initially. - [x] Predictable monthly payments. - [ ] All fees are waived. > **Explanation:** One significant advantage of a fixed-rate mortgage is the predictability of monthly payments, remaining constant throughout the term of the loan. ### How do higher interest rates affect real estate investments? - [ ] They make borrowing cheaper. - [ ] They do not affect real estate investments. - [x] They increase the cost of financing. - [ ] They guarantee higher property values. > **Explanation:** Higher interest rates increase the cost of financing real estate transactions, which can reduce investment returns and make borrowing more expensive. ### What are discount points in a loan context? - [ ] Bonus points awarded by the bank. - [ ] Points used to improve credit scores. - [x] Fees paid to reduce the interest rate. - [ ] Guarantee reduced property taxes. > **Explanation:** Discount points are fees paid upfront to the lender to reduce the interest rate on the loan, effectively “buying down” the rate. ### What represents the lender's actual return if a loan runs to maturity? - [ ] Nominal interest rate - [ ] Monthly payment amount - [x] Effective interest rate - [ ] Origination fee > **Explanation:** The effective interest rate includes the effects of discount points and can thus represent the lender's actual return when the loan runs to maturity. ### Who sets the prime interest rate typically used by banks to set loan rates? - [ ] Department of Treasury - [ ] Federal Deposit Insurance Corporation (FDIC) - [ ] U.S. Congress - [x] Federal Reserve > **Explanation:** The Federal Reserve sets the prime interest rate, a benchmark rate used by banks to determine interest rates for various types of loans. ### What type of interest rate is more likely to increase during inflationary periods to curb spending? - [x] Adjustable Rate - [ ] Fixed Rate - [ ] Amortized Rate - [ ] Deferred Rate > **Explanation:** Adjustable Rate Mortgages (ARM) are more likely to increase during inflationary periods as they are tied to benchmark indices that respond to changes in the economic environment. ### Over a 30-year mortgage term, what impact does a 1% increase in the interest rate have on the overall cost? - [ ] No significant impact - [x] Significant increase in total interest paid - [ ] Results in a reduction of principal amount - [ ] Guarantees higher property value > **Explanation:** A 1% increase in the interest rate over a 30-year mortgage term significantly increases the overall cost due to the compounding interest accrued over time. ### In the context of interest rates, what does APR stand for? - [ ] Annual Payout Rate - [ ] Applied Payments Rate - [x] Annual Percentage Rate - [ ] Accrued Performance Ratio > **Explanation:** APR stands for Annual Percentage Rate, which reflects the cost of borrowing including the nominal interest rate and any additional fees such as closing costs or discount points. ### Which type of mortgage provides fluctuating monthly payments based on interest rate changes? - [ ] Fixed-Rate Mortgage - [x] Adjustable-Rate Mortgage (ARM) - [ ] Interest-Only Mortgage - [ ] Reverse Mortgage > **Explanation:** An Adjustable-Rate Mortgage (ARM) provides fluctuating monthly payments that change based on the current prevailing interest rates during adjustable periods.