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Mortgage Rates Briefly Explained

Rather than explain mortgage rates every time I write about home financing, let me briefly explain the differences between fixed and adjustable rate mortgages, and mortgage points here. Good, clear mortgage information can be hard to come by, but I have tried to make everything as straightforward as possible here.

What is the difference between a fixed rate mortgage and an adjustable rate mortgage?

It’s mortgage rates 101: the difference between a fixed and adjustable rate home loan. Just like it sounds, a fixed rate mortgage stays at the same interest rate for as long as you are paying down the loan, regardless of whether interest rates, in general, go up or down.

Conversely, an adjustable rate mortgage can go up (and sometimes down) based upon the overall interest rate market. Sometimes it is possible to get an adjustable rate mortgage at a much lower interest rate than a fixed rate mortgage, but the rate could skyrocket in a matter of a few years.

Other adjustable rate mortgages (also called ARMs), include a very low introductory mortgage rate for five or seven years, followed by a much higher rate. These loans are designed for home buyers who expect to live in their home a very short period of time, to refinance at a later date, or to flip the home for investment purposes.

While adjustable rate mortgages can be a valuable home buying tool in certain situations, they can also be dangerous, and are partially responsible for the massive rise in foreclosures and collapse of real estate prices that sparked the 2008 recession.

What are mortgage points?

Mortgage points are essentially fees that you pay on a mortgage loan when the loan is distributed. One point is equal to 1% of the mortgage value. So, on a $250,000 mortgage, one point would equal $2,500.

Why would anybody pay mortgage points? Good question. In many cases, if a borrower has poor credit or lending is especially tight, a home buyer may have to pay points to be able to get any mortgage loan at all.

Often, however, mortgage lenders will offer the option of paying points in exchange for a lower interest rate on the mortgage. Sometimes, paying points can actually save a homebuyer money over the life of a mortgage. A reputable mortgage broker should be able to show you how a different points/interest rate combination might apply to your situation (whether you intend to live in your home for 50 years or sell in 5, for example). You can also get several competing mortgage quotes online pretty quickly, and use banks’ online quote tools to compare rates.

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About David Weliver

David Weliver is the founding editor of Money Under 30. He's a cited authority on personal finance and the unique money issues we face during our first two decades as adults. He lives in Maine with his wife and two children.

Comments

  1. Paying down the rate with points also gives the selling broker/bank more up-front income. When the loan is sold off, the bought down rate doesn’t represent that actual risk of the homeowner defaulting. I find buying down with points to be cheap and deceptive.

    I guess you could call me a financial fundamentalist. I don’t think there should be any fees except to a realtor. The bank should go back to making money on the spread. The fees are a way to pay the mortgage guy up front, that sure worked well for the industry.

  2. In an ARM, the “low introductory mortgage rate” isn’t always “followed by a much higher rate”. In general, the more extreme situations people ended up in trouble with were eg versions of ARMs where people also paid only interest for a number of years. But, there are also relatively conservative ARM loans where not only are there no strange gimicks to make the rate artificially low, but where there are limits on how quickly the rate can increase at the other end – so that in the worst case scenario your rate incrementally resets towards the standard current rate – and at any point, of course, you can refinance. As long as you’re not buying too much house, it can be a perfectly reasonable way to set up a mortgage, depending on your situation.

    For example, I bought a condo my second year in an 8 year graduate program, when I knew I was almost for sure planning to move back near family at the end of the program. It was 2004, when rates were VERY low, and buying a 7-year ARM let me get an even lower rate (4.15%) for 7 years, instead of more like 4.85% for a 30 year. Given that there was a more than 90% chance I was going to sell in 7 years, there was no sense paying $80/month for 7 years just to lock in the option of a lower interest rate on someplace I was pretty sure I’d sell! Now, if I wanted to, I could of course refinance and lock in eg a 5% rate for a 15 or 30 year fixed rate (both of which I could handle with my current income), but given that my plans to return near family haven’t changed (parents get older, and it’s hard to deal with health problems from afar…), even now it doesn’t make sense to spend extra money per month to lock in a rate on a place I plan to sell in 2 years.

    Just to defend a reasonable plan in case anyone’s been considering it but is being made anxious by all the negative hype surrounding the poor ways ARMs have been used!

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