While shopping around for a mortgage loan many consumers think that the lower rate is always the better deal. However, there are several different kinds of loans and understand their terms could help save you in the long run. Fixed rate mortgages, may have a higher rate, but it stays consistent over the life of the loan. Adjustable rate mortgages have rates that start low but can increase quickly after a specified period of time.
Why Longer Term Loans Have Higher Rates
When a bank loans you money for 30 years they are taking a risk over a long period of time. They have to trust that you will continue to pay them back over the ups and downs of life for three decades. Financial Institutions have to make sure that they are covering the amount of interest they are going to pay out on deposit accounts with the interest money they make on loans.
The longer you commit your money to a deposit account with a bank the higher interest you will receive. If you have money in a checking or savings you will receive little interest because you can withdrawal your funds at any time. If you deposit money into a certificate of deposit (CDs) you are committing that you will not withdrawal your funds until the end of the term you select. Most banks have CDs that range from 30 days to 5 years.
Due to this fact banks are able to accurately price interest amounts for short-term loans, like with adjustable rate mortgages. It is less of a risk to the bank because they know the market might be requiring them to pay 2.25% on a 5 year CD, but they are receiving 3.15% interest on a 5 year ARM. They know the money is in the bank for 5 years and they are making enough on interest from loans to cover the interest on deposits. The banks aren’t sure what will happen after 5 years, which creates an unknown risk with lending money.
How Timing Can Help You Pay Less
To get the lowest rate and pay the lease amount possible, it’s important to understand how adjustable rate mortgages work and how it could potentially benefit you. If you get a 5 year term on an adjustable rate mortgage for a total of $300,000 and make a 20% down payment, at a rate of 3.25% your monthly payment would be $1,044. Right from the start this might seem like a great option because it is less than you would be paying monthly on a 30 year fixed at a rate of 3.875%.
However, after five years your rate will increase and it’s important to understand how. Your lender will increase your rate to the standard market rate. This is made up of an index rate, usually the worldwide benchmark for short-term loans called LIBOR, and a base rate. The base rate allows for margin in the loan for the lender, and is typically around 2.25%. This means, depending on the economy, your interest rate could go up or down.
A normal rate for LIBOR is around 3.25%. When you add in the base rate of 2.25%, you end up with an interest rate of 6. 5%. This is a huge increase over what you have been paying during the first 5 years of your loan. This means your monthly payment will jump and your rate will be readjusted to the market every year.
Adjustable rate mortgages can save you money if you know how to use them. If you plan on selling your house or paying off your mortgage prior to the end of the initial term, you can take advantage of the lower rate. However, if you plan on making payments over a longer period of time, you will save money with a 15 or 30 year fixed rate.