Mortgage Rates 101

American poet Robert Frost described education as “hanging around until you’ve caught on.” If “hanging around” has brought you here to learn mortgage rate basics, congratulations! You’re about to be educated.

Stability advantage

Your lesson begins with an introduction to the popular fixed mortgage rate. As you can probably guess, a fixed rate does not change for the life of the mortgage. This means that your monthly principal and interest payments are fixed, also. Your total mortgage payment could still change periodically if it includes an escrow of taxes and insurance. But any such changes would be related to that, and not to your loan’s principal and interest.

The primary advantage of a fixed rate is stability. You can buy a home knowing what your payment will be until your loan is paid off. If your income rises over time, you’ll enjoy increased financial flexibility because your housing expenses will be stable.

Fixed rates vary depending on your credit profile and on the length of the loan. Shorter loans have lower rates. The usual length options are 15, 20, or 30 years, with 30 years being the most common.

Flexibility trade-off

Mortgage rates that aren’t fixed are known as adjustable. These adjustable rates are somewhat more complex than fixed ones, and therefore require a longer explanation.

You’ll typically see adjustable rates described with two numbers, followed by the adjustable-rate mortgage abbreviation ARM, as in 5/1 ARM or 7/1 ARM. The first of the two numbers defines the initial period for which your rate is fixed. The second number defines the interval at which the rate can be changed, once the fixed period expires. A 5/1 ARM has a fixed rate for the first five years, for example -- then the rate can be adjusted every subsequent year. Rates are generally lower when the initial fixed period is shorter.

An adjustable mortgage rate is the sum of two components, an index and a margin. The index is a published rate that changes based on macroeconomic conditions. Two indices commonly used for mortgages are LIBOR and one-year CMT. The margin is a fixed amount that the lender defines based on your credit qualifications. 

The primary advantage of an adjustable rate is its upfront flexibility. Generally, you can lock in a lower payment for the first few years, in exchange for the risk that the rate and payment might go up later. Some lenders even offer very low, interest-only payments during that fixed period. These low payments look good on paper, but they’re risky in real life. Don’t proceed unless you reasonably expect to increase your income, sell the home, or refinance the loan before the rate changes take effect. Also, while adjustable rates can go down, they are unlikely to drop much from current historical lows.

Your homework assignment is to use a mortgage calculator to determine how much of a mortgage payment you can afford. From there, you can research current fixed and adjustable mortgage rates to understand the affordability of each option.