Credit Cards: How Do Mortgage Interest Rates Work?

Friday, June 13, 2008

How Do Mortgage Interest Rates Work?

Are you confused by terms like ARM and PITI and FRM? This article will break down mortgage interest basics so you can get a better understanding of the mortgage market before you buy.

Most loans break down into two categories - fixed-rate interest loans and adjustable rate (ARM) interest loans. We'll look at both of these opportunities, along with the benefits and the drawbacks.

Fixed Rate Mortgages

When interest rates are low (below the 8-10% marker), fixed rate mortgages are often the best option for most borrowers. They allow a steady rate of interest throughout the course of your mortgage and regular monthly payments for which you can budget and plan. Because the payments are predictable, there's no shock or sudden increase in payments even when interest rates go up for others.

Adjustable Rate Mortgages (ARM)

Adjustable rate mortgages basically shift the risk of inflation from the lender to the borrower. They can be tricky to navigate and if you're a first-time home buyer, you may want to consult with a financial adviser or mortgage broker. Make sure you ask what the worst-case scenario would be, and make sure that you could handle that hurdle if it ever came up.

Basically, an ARM or adjustable rate mortgage has a variable interest rate that's tied to a particular financial index which rises and falls with the economy. The initial rate is usually lower than the rates offered with fixed rate mortgages. While most home buyers with an ARM will save more money in the long term over fixed rate borrowers, they're still assuming a risk.

For example, if inflation begins to rise, the adjustable mortgage rate can go higher than a fixed rate. Because borrowers can add a margin of a few points on top of the standard market rate, make sure you check their "caps." On most adjustable rate mortgages there is a lifetime cap and an annual cap - these dictate how high or how low the interest rate can go in either direction. The annual cap usually ranges between 1.5% to 2.25% while the lifetime cap can typically be as high as 5%-6%.

Essentially, fixed rate mortgages are predictable. You know what you're getting and how much your monthly payments are going to cost you. If interest rates are low, you want to lock in with a low monthly rate and you don't want an adjustable rate. On the other hand, if interest rates are high or climbing, an adjustable rate mortgage could save you money in the long run when interest rates come back down.

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