Smarten Up: Learn About Fixed Mortgage Rates

Are you surprised to learn that on the game show “Are you Smarter than a Fifth Grader?” there have only been two people who have won the million dollar grand prize? Almost all adults have completed high school – 12th grade – so it’s somewhat surprising that there aren’t more people who have as much knowledge as someone in fifth grade. With so many people lacking basic knowledge, though, it’s not surprising that several recent surveys have linked poor math skills to high foreclosure rates, because understanding mortgage loans require some math skills. Don’t make your mortgage a financial conundrum – learn some basic lessons about mortgage rates and prove you’re financially literate about home loans.

Mortgage rates exposed

A recent study published by the Atlanta Federal Reserve Bank asked borrowers five math questions that involved division, percentages, and fractions. Participants were asked, for example, to calculate the price of a $300 sofa on sale for half off, the price of a used car that’s selling for two-thirds of its original price, and a basic compound interest question. Only 13 percent of participants answered all questions correctly. That left a whopping 87 percent who were mathematically challenged.

One of the more alarming findings, though, was that 30 percent of people who scored in the lowest bracket didn’t know if they had a fixed- or adjustable-rate mortgage.  Do you?  And if you do, do you understand the difference?

Fixed-rate mortgage

The most common mortgage is a fixed-rate loan, with a monthly payment that stays the same during the entire term. The interest rate is set at closing. Each payment goes partly to principal and partly to interest. At the beginning of a fixed-rate mortgage, almost all of the monthly payment is directed toward interest, but as the loan progresses through its term, more is funneled toward principal.

When mortgage rates are low, it’s a great time to lock in a fixed-rate loan. If rates are high, you can always refinance if mortgage rates drop.

Adjustable-rate mortgage

With an adjustable-rate mortgage (ARM), the interest rate changes during the life of the loan. The mortgage rate is tied to an index, such as the Constant Maturity Index (CMI) or the London Interbank Offered Rate (LIBOR).  There’s generally a yearly cap and a lifetime cap, which governs how much the interest rate can increase. Because the mortgage rate is unpredictable, it can be hard to budget on a regular basis.

If you’re applying for a loan and reviewing your options, you’ll find that ARMs, at first, offer lower rates than their fixed-rate counterparts. However, since the ARM will keep changing, and the fixed-rate mortgage will remain the same, it’s likely that, during the term of each loan, there’ll be periods when you’ll be paying a higher mortgage rate with the ARM than with a fixed-rate mortgage.

It only takes a small effort to become financially literate, especially when it comes to your mortgage. Now that you know the difference between a fixed-rate mortgage and an ARM, it’s a good bet that you are smarter than a fifth grader – at least when it comes to mortgage loans.