Besides definite consumer advantages due to brisk competition, the vast array of available loan options can often be overwhelming for prospective borrowers. Unlike unbecoming haircuts or clothing styles, unsuitable mortgage loans have far-reaching disastrous financial consequences. Following is a basic overview of mortgage rates and the ways in which they directly and significantly impact a would-be homeowner’s pecuniary picture.
- Variable
As its label implies, a variable interest rate is subject to change. In an effort to offset this element of uncertainty, lenders extend brave borrowers a break via a reduced initial interest rate. Common adjustable rate mortgage (“ARM”) schemes feature below-market interest rates for the first one, three, or five years following loan origination. Length of initial interest reduction and corresponding percentage rates are inversely proportional.
Although attractive at first glance, ARMs have caused many borrowers to lose an arm, a leg and the shirts on their backs – in addition to their homes. Such colossal failure is caused by subsequent interest rate hikes that yield unmanageable mortgage payments. Of course, the inevitable outcome of such an onerous obligation is foreclosure, of course.
- Fixed rates
Fixed interest mortgage debtors face no possibility of unpleasant financial surprise in their futures. Although fixed-rate loans feature no initial interest rates reduction incentives as do ARM analogues, borrowers who get a mortgage at a fixed rate usually fare far better than their variable-rate counterparts. Consider the following illustration.
Aggressive Lender offers Paul and Peggy Perplexed the following options for a $150,000 new mortgage loan proposal:
a) 1-year ARM at 3.29 percent with initial monthly payment of $656.11
b) 30-year fixed rate of 4.1 percent with fixed monthly payment of $725.67
At first blush, the prospect of ARM loan monthly “savings” of $69.56 looks great. This approach has a serious drawback, however: The Perplexed family owns no foolproof crystal ball.
What if interest rates rise by just one-half a percent the following year? The Perplexed household budget must now sustain a new monthly payment of $711.07. If interest rates rise by a mere one-percent margin, their revised monthly outgo will rise to $754.05. If double-digit interest rates that characterized the 1980s and 1990s decades rematerialize, the Perplexed couple must then maintain a whopping monthly payment of $1769.53 on their slightly-reduced balance of $147,000 at a new interest rate of 14 percent.
Don’t discount power of discount points
Discount points are functionally identical to insurance premiums. Each prepaid discount “point” equals one percent of gross loan proceeds and buys a permanent interest break of .5 percent.
Thus, Paul and Peggy could have acquired long-term peace of mind and a lighter budgetary burden for a one-time outlay of only $2,460. As discount points are fully tax-deductible and Paul and Peggy belong to America’s 35-percent tax bracket, their true cost is only $1,599.00.
Obvious conclusions and optimal outcomes
The foregoing discussion aptly demonstrates why it is invariably best to get a fixed rate mortgage. Volatile property values amidst an ambiance of rising interest rates dictate extended initial stays in newly-acquired residences. Fixed-rate mortgage loans let borrowers hedge all bets. In the event that prevailing interest rates continue to climb, their position is secure. If the opposite scenario emerges, they may improve their financial stations with a refinance or residential upgrade.
