Make Sense of Interest Rates
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Can Someone Explain How Mortgage Interest Rates Work?
Confusing for many first time home buyers, interest rates must be compared in an apples-to-apples environment as the true rate for a mortgage loan can be affected by closing costs or other “hidden” expenses. Fixed rate loans can be compared rather easily. Since the rate never changes over the life of the loan, the stated, or “simple interest rate,” is often the true rate that can be compared with others. However, it is necessary to learn the closing costs associated with each loan being compared. If the costs are comparable, the stated rates can easily be compared to determine which is the best offer. If the costs for one loan are much higher than another with the same stated rate, the one with the lower closing costs will result in a lower effective rate, or Annual Percentage Rate (APR) than the other. Should one consider an Adjustable Rate Loan (ARM), the understanding and comparisons are more difficult. There are five basic components of most ARM's:
- Start rate – the initial rate (and the rate you qualify for) that is in effect until the first adjustment date.
- Index – the “base rate” used to determine the new rate on adjustment dates. The U.S. Treasury (T-Bill Index) bills, notes and bonds auction prices, the London Interbank Offered Rate (LIBOR), and the 11th District Cost of Funds Index (COFI) are the most common indexes used in American mortgage loans.
- Margin – the percentage that will be added to the index to form the new rate at each adjustment date.
- Adjustment rate cap – the maximum increase in the rate that can occur at each adjustment rate change date, regardless of the actual computation of the index and margin. In a shorter term ARM (six month, one year, and two year), this cap is often two per cent. But it could be higher or lower.
- Lifetime rate cap – the maximum increase in the rate than can occur over the life of the mortgage, regardless of the computation of the index and margin. Lifetime caps are often in the six per cent range.
All of these components must be examined to determine the best rate structure for the situation of the borrower. Comparing these factors becomes easier and more understandable with practice. But remember, all components are important to the whole. For example, an advantage in an adjustment rate cap can easily be countered by a disadvantage in a lifetime rate cap. A wonderful low start rate can quickly become a distant memory if the loan has an unfavorable index and/or margin. Understanding interest rates and how they work will help the borrower make the best decision when choosing a mortgage loan.