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Calculating Loan Payments

You need extra money for house renovations, especially if you are planning a full remodel or want to buy some new appliances. Usually this means that you will take out a line of credit or loan. It's important to understand that a loan isn't free money, and you will have to pay back a loan, usually more than you were actually given due to interest. That's why it is so important to get a low interest rate. Here are some tips on calculating your loan payments and figuring out what you should owe.

The Basics

If you gave someone $1,000 at a 5 percent interest rate that was compounded annually, the bank would pay you $5 a year. That seems reasonable right? Well, that's not how banks actually work, because unfortunately they do need to make some money. Traditional mortgages are designed so that at the end of some period of time, say 10 years, you will own the house. Remember, that when you deposit money in a bank and get paid interest, the bank doesn't get to keep your $1,000, they're just paying for the use of it. To own a house, the payments must be so that you are not only paying interest on the amount of money borrowed or the principal, but that you are also paying some of the principal (the actual value of the house) with every mortgage payment.

How Compounded Interest Works

The other reason that you can't use a simple interest in mortgage interest rates is that the interest is compounded, which means that it is added to the principal on a regular basis. That compounded period was one year in the example from earlier. It's normally paid per month for mortgages. However, compounding periods are often daily on shorter loans or even continuous. Compounding interest is what makes mortgage loans seem too high to afford, but it is better to understand loans by seeing that first the interest accumulates on a principal amount.

What are the Loan Terms?

All loans will have certain terms, meaning what you pay each month for a period of so many months at a certain interest rate. If you have a 30-year term, that means your loan payments will be once a month for 30 years. For this reason, you want to make sure that you can afford the payments in the future as well as presently. The amount should not exceed 38 percent of your entire income that you have coming into the house. You also want to make sure that the interest rate isn't ridiculous. Something as low as 8 percent is normal for a homeowner with an A credit rating.

Loan Calculators

Your specific terms are based also on your property taxes, homeowner's insurance and PMI or private mortgage insurance. To figure out a loan payment, you can use a variety of loan calculators online that will help you figure out your payments over time. CNN has a great mortgage and loan calculator located here.

What to Avoid

Typically, you don't want to get into a high risk loan or mortgage. Option ARM loans are the most dangerous types of loans. They give you a lot of flexibility when your monthly payment is due, you can pay a little or a lot, however, if you don't pay, your payments will get extremely high, extremely quickly. Adjustable rate mortgages are also very dangerous. Although you may start out very low, you may end up with a 19 percent interest rate at the end of your loan period. That is exhausting on your budget. You should make sure to read your loan terms before accepting anything.