If there’s been one financial signal over the last five years, it’s been the rise and fall of the mortgage industry. Once a power player in the financial world, loaded with small firms and big players alike, it’s no longer what it once was. A collapse in 2007 and a subsequent financial meltdown just a year later pushed what was once a huge industry into a corner that’s proving difficult to escape from.
Nevertheless, the mortgage industry is recovering, both for consumers and the many professionals it employs. The days of foreclosures are still here, albeit on a scale significantly smaller than what the past three years have brought us. Failed banks, likewise, are no longer a weekly occurrence. And the sales-based center of the whole industry – mortgage brokers – appear to be quickly bouncing back.
In this guide, we’re going to look at one of the most contentious and widely debated elements of a home mortgage – the type of interest rates that are tied to it. There are two basic types of mortgage, and several variations on the basic mortgage itself. These are adjustable rate mortgages and fixed rate mortgages. Almost all homes are purchased using one or another of these financing options.
Let’s dive right in and start with fixed rate mortgages, once a staple of real estate-based lending. For the better part of seven decades, the majority of home mortgages issued used a fixed rate for interest on the loan. This means that the loan itself was repaid, along with a small amount of additional fees. These added fees are considered interest, and are based on the length and balance of the loan itself.
With a fixed-rate home loan, the interest rate applied to the loan never changes. It’s constant – a flat rate that’s decided on in advance of the loan itself being issued. Generally speaking, the interest rate of a fixed rate mortgage is tied to the average interest rates of the period in which it’s issued. As an example, a loan issued during a period of 5 percent average rates will likely have a 5 percent rate.
There are numerous advantages to this type of loan. The most obvious is that there’s no unexpected risk of the mortgage’s interest rate rising. A fixed rate loan has a constant, unchanging interest rate, and as such it’s easy to plan for the loan’s expenses. This means that once you’ve bought a home, you will know exactly how much needs to be paid each month to service your loan’s balance.
However, there are also disadvantages to this type of loan. If a fixed-rate mortgage is taken out in a time of relatively high interest rates, the loan’s constant interest rates won’t adjust to the market rate. This means that if interest rates fall overall, you could be paying significantly more on your loan as interest than you would be if your loan simply followed the average month-by-month interest rates.
Now, let’s look at the other option for would-be homeowners – an adjustable rate mortgage. Known to many as ARMs, these loans are issued with two different interest rates. The first is the initial rate, also known as the ‘teaser’ rate. This is the loan’s fixed interest rate for its initial pre-maturity period, and is generally slightly lower than the rate on a fixed-rate home loan or other type of mortgage.
Then there’s the second interest rate – the true interest rate, that’s applied to the loan following its teaser rate period. At this point, an adjustable rate mortgage loses its fixed rate and adjusts based on the market’s interest rates. If overall interest rates are low, the mortgage’s monthly interest rates will decrease. If overall rates are high, it’s likely that the loan will increase to adjust to them.
This means that, in periods of low interest rates, an adjustable rate mortgage can be more affordable than a similar fixed-rate loan. However, in periods where interest rates suddenly increase, adjustable rate mortgages can quickly grow into unaffordable financial monsters. This is one of the reasons for the recent housing crisis, in which many homeowners were unable to repay interest on their ARMs.
In the end, the ideal choice for your mortgage may not be the same as that of someone else. There’s a priority list for homeowners, and it tends to vary from one couple – or individual – to another. An adjustable rate mortgage or a fixed rate mortgage could work for you – the ideal choice, as with any type of long-term financial decision – depends on your needs, your assets, and your risk tolerance.