There are several different types of interest rates when it comes to mortgages.
The two most common types are fixed and adjustable. They mean exactly what they are defined as.
A fixed interest rate is locked in for the life of the loan. However, if a borrower decides to refinance, that interest rate is no longer good. They can lock into another fixed interest rate on the refinance as borrowers are not limited on how many times they receive a fixed interest rate loan.
An adjustable rate mortgage (also known as ARM) begins with a locked rate. The locked rate can stay that way depending on what ARM you choose. There are several different types of ARM mortgages; they are 3/1, 5/1 and 7/1. The first number states how long the rate will be locked for. The 1 stands for every year after that gets adjusted.
For example:
A 3/1 ARM on a 30-year loan would be that the interest rate is locked for the first three years. The final 27 years the rate would adjust.
The adjustment is based on the Cost of Funds Index (COFI), the London Interbank Offered Rate (LIBOR) and the constant-maturity Treasury securities. However, most of the adjustments are based on the COFI and LIBOR.
|
Fixed Rate Mortgage |
ARM |
||
|
Pro |
Con |
Pro |
Con |
|
Rate locked in for life of loan |
Slightly higher interest rate than ARM |
Low rate, low payment to begin |
Rates, payments change year to year |
|
Consistent monthly payment |
Need to refinance if want lower rate |
No need to refinance |
Difficult to understand |
|
Easy to understand |
If market improves, could cost you more than when started |
Cheap alternative for someone unsure about living in same place for so long |
Potential for prepayment penalities |
Now, depending on the loan term. It can affect the interest rate as well.
The usual loan term is 30 years. This allows for a smaller monthly mortgage payment. Borrowers do see a slightly higher interest rate but get that smaller monthly mortgage payment.
If you decide you have the money, you can choose a smaller loan term. By choosing that lower loan term, you’ll see a much smaller interest rate. However, you will see a much higher payment.
For example, current markets show that on a 30-year loan interests rates are around 4.25%. On a 15-year loan, the rate is around 3.5%.
Now that you’ve learned about the interest rates, make sure to check in with a mortgage professional to see if a fixed-rate or an adjustable-rate mortgage is best for you.