Everything You Need to Know about Mortgage Interest Rates
Unless you’re incredibly well-off, if you want to buy a home, you’ll need some money. Unfortunately, money isn’t free, so, when you take out a home loan, you’ll have to pay a percentage of the loan amount, called interest, which is usually expressed as an annual percentage rate (APR). Interest rates rise and fall depending on a variety of market factors, and, since interest can add up to a very large amount of the lifetime cost of buying a home, it’s essential that you understand exactly how it works.
Interest Rate vs. Annual Percentage Rate
While we just mentioned the concept of APR, it’s important to understand what it really means. APR isn’t just interest, it also includes other expenses and fees that borrowers will have to pay. These include things like certain closing costs, broker fees, and discount points. For example, an $200,000 loan might have an interest rate of 6%, but after $5000 of closing costs and broker fees are added into the mix, the loans actual cost-- or APR, ends up being 6.15%. It’s important to be careful when looking at the APR for adjustable-rate mortgages (ARMs), as this will not reflect the maximum interest rate you might have to pay (if interest rates go up.)
Amortization and Home Loan Interest Rates
While most people understand that they have to pay interest on their mortgage, many don’t understand the concept of amortization. Due to amortization, every mortgage payment you make is divided into two portions, interest and principal (the actual sum you are borrowing). If, for example, you have a 30-year fixed rate mortgage, your actual payment may not change over the life of the loan, but the proportion of interest and principal your paying will. As you get closer and closer to paying off your loan, the proportion of your monthly payment that goes to interest decreases, and the proportion of the payment that goes toward paying the principal goes up.
Negative Amortization and Home Loan Interest Rates
Hopefully, you now understand the concept of amortization. But, you might not know that some loans are actually negatively amortizing. That means that the borrower is actually making payments that are smaller than the loan’s interest, thereby increasing the size of the loan’s principal over time. Some kinds of mortgages, including graduated payment mortgages (GPMs) start as negatively amortizing loans with incredibly small payments, and, as the payments increase in size, they become typical amortizing loans. Another kind of negatively amortizing loan can be a payment option ARM, which allows both interest-only payments and minimum payments, which may be far less than the minimum required payment needed to pay off the loan in full by the original payoff date.
Fixed vs. Variable Interest Rates
When it comes to looking at home loans and their interest rates, one of the biggest choices you’ll have to make is between getting a mortgage with a fixed rate, or variable interest rate, often referred to as an adjustable-rate mortgage (ARM). While fixed interest-rate mortgages have interest rates that stay the same for the life of the loan, variable or adjustable rate mortgage rates can go up and down over time.
For most borrowers (especially those who like the house they’re buying and plan to stay there a long time), a fixed-rate mortgage is best, because it provides long-term financial security-- and you know your mortgage payments won’t suddenly be increased based on changes in the market.
Despite that, ARMs are still attractive to borrowers, especially those who want to take advantage of a period of low interest rates. ARMs usually have both a fixed and a variable interest-rate period. For example, a 7/1 ARM has a 7-year fixed rate period, after which the interest rate is adjusted every year. ARM variable interest rates are always based on a market index, such as the LIBOR index, an index which measures the rate at which banks in England loan money to each other. While ARM interest rates can get rather high, there is always a maximum rate, known as a cap, that limits how far they can go.
Most borrowers who get ARMs don’t want to keep them for the long-run; instead, they want to lock in a low interest rate for a short period of time, and either sell the home or refinance to a fixed-rate mortgage before the variable-interest rate portion of the loan begins.
How to Reduce Your Interest Rate
Since paying interest can get incredibly expensive over time, it only makes sense that a smart home buyer would want to take a look at all the ways to reduce their interest rate. When it comes to cutting your interest rate down to size, there are obvious choices and not-so-obvious ones.
First off, the obvious: by improving your credit score, being able to offer more money down, and improving your DTI (debt-to-income ratio) you can make yourself a more attractive (and less risky) borrower-- and that means lenders may be more likely to give you a favorable rate. Of course, you can also check out FHA loans, VA loans, and USDA loans (if you qualify), which often offer a lower interest rate than privately-insured mortgages.
Purchasing Discount Points from a Lender Can Decrease Your Interest Rate
One less obvious (but still popular) way to reduce your interest is to buy discount points from a lender. Discount points are a form of prepaid interest, and the cost of each point is typically calculated by taking 1% of the amount of the loan. Since points can reduce your interest rate, they can decrease your monthly mortgage payment, as well as decrease the amount of money you pay in interest throughout the life of the loan.
Some lenders will allow you to buy up to 3 points at closing, while others may not allow you to purchase points at all, so if you’re interested in buying points, you may want to inquire about this early on in the process. While it varies from lender to lender, 1 point, for example, will usually decrease your interest rate by between 0.25% to 0.375% per year.
Speak with a Mortgage Specialist
At the end of the day, since you could end up paying half (or even more) of the total cost of your loan on interest, it pays to make sure you’re getting a good rate. Interest Rates vary from lender to lender and loan to loan. They can be fixed throughout the life of the loan or adjusted at set intervals. The most important thing to do is to make sure you let your lender know that you're interested in getting a good interest rate on your home loan (see what we did there?). So do your research, talk to a professional, and become informed before making any big decisions about purchasing a home.