Mortgage interest rates have been a hot topic in the nation since 2008. We have seen the lowest ever recorded interest rates, which transpired in November of 2012. As the market has strengthened this year, mortgage rates have ever so slightly increased.
This has led to some anxiousness about the real estate market, even deterring some from buying.
At NeighborWorks Orange County we would like to put mortgage interest rates into perspective. Over the last four decades, we’ve seen a wide variety of different interest rates. The 1980s brought the highest rates in history, with homeowners seeing rates above 15%. Some accounts even depict rates coming in right below 18%.
In the last six months, interest rates have increased anywhere from a half a percent to a percent. We are still in a market below 4%. Compared to the near 18% thirty years ago, interest rates are at the bottom of the spectrum.
The most important factor in buying a home is determining if you are ready. That’s why we focus so diligently on our homebuyer classes.
Interest rates are part of the home-buying equation. More importantly, it comes down to deciding which loan type is best for you. There are two main types of loans with variable options within each classification. Each loan creates different circumstances, terms, and adjustments for interest rates during the duration of the loan.
Fixed Rate Mortgages
Fixed rate mortgages are fully amortized loans. This means that the borrower will have the same interest rate throughout the loan term, aka “fixed.” This fixed cost approach gives homeowners the same payment every month, making long-term budgeting and planning easier.
Typical fixed rate mortgages come in 10-year fixed, 15-year fixed, or 30-year fixed terms.
Fixed rate mortgages are best for individuals and families planning to stay in their home for a long time. By locking in the interest rate, they eliminate the risk of their interest rate rising later on in the loan term. Should interest rates drastically drop in the future, homeowners can look into refinancing options.
Traditionally interest rates on a fixed mortgage are typically slightly higher than other loan options. That is because the buyer is locking in the current interest rate from the bank. If interest rates drastically increase down the road, the bank will still honor the agreed upon interest rate. To offset that, the bank writes fixed-rate mortgages at a slightly higher rate. The difference in rates between loan types varies depending on the current interest rate climate.
Clients typically believe they will keep their same loan for the full duration of their loan. This means they aren’t inclined to evaluate other loan options. In truth, the majority of clients actually end up either selling their home or refinancing during the initial term. Reasons for refinancing include adjusting to a lower rate or to cash out value for home improvement, addressing an emergency, or to pay for college.
Adjustable Rate Mortgages
The other main option is an adjustable rate mortgage (ARM). These loans are not fully amortized, which means that the interest rate will adjust during the term of the loan. The amount that it can adjust is determined by the “index.” For the first part of the loan, the interest rate is fixed.
These caps control all subsequent adjustments:
- Initial adjustment cap: Determines maximum amount the loan can increase the first time after the fixed rate period.
- Subsequent adjustment cap: Outlines the amount a loan can increase in the following adjustments.
- Lifetime adjustment cap: Sets the maximum the loan can increase throughout the lifetime of the loan.
The most common types are 3/1 ARMs, 5/1 ARMs, 7/1 ARMs, or 10/1 ARMs. The first number, such as the 3 in 3/1 ARMs, outlines the length of the initial fixed period. The amount adjusted is set by the index, which is a neutral party that evaluates the market and publishes a fair interest rate. In certain market situations, the rate can actually go down.
ARM loans work best for families or individuals not planning on staying in the home for very long or are anticipating a positive change in income or financial situation. For example, if a homeowner will have a better job in two years or if they are anticipating being moved for work, they would benefit from a lower payment during the initial fixed period.
Should the owner decide to stay in the property longer, there is more risk that the interest rate will go up. This creates changes to the monthly payment over time.
We advise all clients considering an ARM loan to request the lender calculate the highest payment possible on the loan in question. This gives the borrower the opportunity to evaluate the loan on both the best terms and if the market changes drastically.
In this low-interest market, adjustable rate mortgages are viewed as “bad” loans. It’s not a matter of if the loan is good or bad, but rather what is best for your unique situation.
Additionally, ARM loans are perceived as having unlimited ability to increase the rate. That is not accurate. ARM loans have limits, or caps, on how much the interest rate can fluctuate. This protects the loan holder from having their loan interest rate increase too far.
Being Prepared for the Borrowing Process
Applying for and selecting the best loan for you and your family can be overwhelming. That’s why we at NeighborWorks Orange County encourage all homebuyers to attend our Homebuyer Classes. Here we outline everything you need to know about buying a home.
This is the best advantage you can give yourself when approaching purchasing a home. After going through the class, you will have a strong understanding of all the different loan options available, as well as which one is the best route for you.
Should you have any questions throughout the process, partner with one of our counselors. They walk with you to give you suggestions on the best path forward on your unique journey to homeownership. Their priceless experience and unbiased answers are a powerful asset to anyone planning on purchasing a home.