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A Consumer Guide To
Mortgage Interest Rates

  • Why are mortgage rates important?
  • How do fixed-rate mortgages work?
  • When does it pay to refinance your mortgage?
  • How do adjustable rate mortgages work?

Why Are Mortgages Rates Important?

Two-thirds of U.S. households own their own homes (as opposed to renting), and most homeowners pay a mortgage. Thus, the level of mortgage rates determines how much all these homeowners have left to spend on other things. How much people can spend on other things, in turn, affects the overall economy.

Interest rates on home mortgages are important because mortgage interest is a major item in many people’s budgets. Even small changes in mortgage interest rates can have a large impact on how affordable it is to own a home. That’s important, because homeownership is the major way many families build up wealth.

The interest payments over the life of a mortgage often add up to more than the amount of the mortgage loan. For example, the interest payments on a 30-year, $100,000 mortgage at a 7% interest rate will add up to about $140,000 over the 30 years.

People who have mortgages may deduct the interest they pay from their income in calculating how much income tax they have to pay. That’s a significant benefit of owning a home.

How Do Fixed-Rate Mortgages Work?

The interest rate for a fixed-rate mortgage remains the same for the life of a mortgage, and the monthly payment also stays the same for the life of the mortgage.

For example, a 30-year, $100,000 mortgage at an interest rate of 7% requires a monthly payment of $665.30. Every month for 360 months, the payment of principal plus interest equals $665.30.

The vast majority of the monthly payment in the early years of the mortgage is for interest, and only a small amount reduces the principal, the amount of the original loan still owed. The opposite is true in the latter years of the mortgage.

Therefore, most of the monthly payment in the early years of the mortgage is income-tax-deductible, but very little of the payment in the later years is deductible. Usually, however, homeowners will find the payments more affordable in the latter years, because incomes generally rise, and inflation reduces the "real" burden of the fixed payment.

When Does It Pay To Refinance a Mortgage?

Refinancing — taking out a new mortgage and paying off your old one — may be advisable if mortgage rates are lower than when you took out your mortgage.

Refinancing involves some costs, though — legal fees, points on the new mortgage, and others — so refinancing doesn’t pay if rates have fallen only slightly.

Experts usually advise against refinancing unless the new rate is at least two percentage points lower than the rate you’re currently paying.

How long you plan to stay in the house is another factor to consider. If you don’t plan to stay in the house very long, you may not enjoy the benefits of the lower rate long enough to make the costs of refinancing worthwhile.

People sometimes refinance their mortgages for reasons other than to save on interest costs. They may want to take out a larger mortgage, for example, in order to use the extra cash for a major purchase.

How Do Adjustable-Rate Mortgages Work?

An adjustable-rate mortgage has an interest rate that moves up and down based on changes in some other rate, called the "index rate." A common index rate is the rate on a specified U.S. Treasury security.

An ARM typically has a lower initial interest rate than a fixed-rate mortgage, but the ARM rate is adjusted periodically (perhaps every year), based on changes in the index rate.

Many ARMs place a limit on how much the interest rate can rise in a single adjustment or over the life of the mortgage. Similarly, some ARMs limit how much the monthly payment can increase as a result of a periodic adjustment. That limits the risk that the borrower will be unable to make the payments, but a potential problem related to the payment cap is that of "negative amortization," or an increasing mortgage balance. That can happen if the payment cap does not allow the increase in the payment to cover the increase in the interest due each month.

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