Different Types of Interest Rates in Mortgage Loans Explained Simply
When a person applies for a mortgage, they may find that several interest rates are available. They must understand each rate to make the right decision for their financial situation and needs. The interest rate of the loan directly impacts the overall affordability of the home and the cost of borrowing.
Fixed-Rate Mortgages
When a person wants a predictable monthly mortgage payment over the life of the loan, they need a fixed-rate mortgage. The interest rate remains the same for the length of the loan term, so the borrower won’t need to worry about market fluctuations. The payment may change based on changes in real estate taxes and insurance, but the principal and interest portions of the payment remain consistent. People who plan to stay in their homes long-term benefit from fixed-rate mortgages, although the interest rate is slightly higher compared to other options.
Adjustable-Rate Mortgages
An adjustable-rate mortgage (ARM) features an interest rate that fluctuates periodically after the initial introductory rate. The initial rate is often very low and is referred to as a teaser rate. This rate remains in place for a predetermined period. Once that period ends, the interest rate changes based on current market conditions. These changes occur at regular intervals and are based on the Secured Overnight Financing Rate (SOFR) or another index outlined in the loan documents. The adjustments may lead to a higher monthly mortgage payment, but the payment could also drop. People who plan to be in their homes for a short term often choose this option, but there is a risk involved if they remain in their homes past the introductory period, as rates could climb drastically.
Hybrid ARMs
People might consider taking out a hybrid ARM when purchasing a home. This financial product combines elements of fixed and adjustable-rate mortgages. The borrower benefits from a fixed interest rate for a predetermined period before moving to an adjustable rate. They benefit from payment stability initially while receiving a lower starting rate. Borrowers who plan to move or refinance within the predetermined period often choose this option so they don’t need to worry about immediate rate fluctuations. However, if they remain in the home past this period, they usually refinance so they don’t have to worry about rate fluctuations.
Interest-Only Mortgages
An interest-only mortgage allows a borrower to pay only the interest for a predetermined period. The loan principal doesn’t decrease during this period, but the monthly payment is significantly lower. Individuals with irregular income and those expecting future earnings growth often choose this option. When doing so, they must understand that their monthly payments will jump drastically when the initial period ends. If home values drop, the person could find it difficult to refinance the home. They may also find they can no longer afford the house when the payments rise if they haven’t seen the anticipated rise in income.
How To Choose
When comparing mortgage products, borrowers should consider their financial stability and the length of time they plan to stay in the home. Risk tolerance also plays a role in this decision. Individuals seeking a predictable mortgage should opt for a fixed-rate product. Those willing to take on more risk may consider an adjustable-rate mortgage (ARM) or a hybrid ARM to benefit from lower initial rates. When interest rates are rising, many people opt for a fixed rate. As they fall, an ARM might be the better choice.
Every person must consider their circumstances when making this decision. They should also use a mortgage loan calculator to explore different scenarios and see which product best meets their needs. A financial advisor can be invaluable when making this choice, as they guide the borrower in selecting a loan that aligns with their financial goals while ensuring the payments are manageable and home ownership doesn’t become a burden.
