If you’re thinking of taking out a mortgage to finance a property purchase, it’s worth getting to know how different mortgage rates work.
With an abundance of competitive mortgage products available on the market, the type of mortgage you choose is instrumental in helping you reach your financial goals. Read on to learn how mortgage rates are treated for different products so that you can make an informed decision.
Average mortgage rates in the US
Our mortgage market is highly competitive, which means borrowers can benefit from relatively low interest rates charged with loans.
According to Freddie Mac, the average monthly interest rate for a 30-year fixed mortgage is 3.94%.
How are mortgage rates calculated?
Interest on mortgages is generally paid monthly, which means you can divide the annual interest rate by 12. For example, if you took out a mortgage of $600,000 at 6.5% interest over 30 years, you would pay a monthly rate of 0.54%. This means that each month you would pay 0.54% interest on the principal amount.
For the first repayment, you would pay $3,240 interest plus principal. The following month, the principal would be less, which means you would also pay less interest.
What are the different mortgage rate types?
If you’ve saved up for a down payment and you’re thinking of entering the property market, make sure you know what options are on offer. The most common mortgage types are the adjustable rate mortgage (ARM) and the fixed rate mortgage (FRM), among others, which are outlined below.
1. Adjustable rate mortgage (ARM)
Also known as a variable rate mortgage, an adjustable rate mortgage (ARM) is a mortgage where the interest rate can adjust throughout the life of the loan, depending on a specific index. This index reflects the borrowing cost to the lender, which is then passed on to the borrower.
Most lenders enable you to select an index while others rely on a major index for the majority of their mortgage products. The initial rate on an ARM is normally lower than a fixed rate mortgage, so an ARM can be beneficial if you are only planning on staying in the home for a short period of time. The initial rate is normally offered for a specified period, and the ARM will adjust to the fully indexed rate after this period ends.
To work out what your fully indexed mortgage rate is, simply add the margin to the associated index.
Adjustable rate mortgages are regulated by the federal government and are generally offered at the lender’s standard or variable interest rate.
What are the types of adjustable mortgage rates?
Some of the adjustable mortgage rates are as follows:
- 5/1 ARM: First adjustment takes place after five years, and then it adjusts on an annual basis.
- 5/6 ARM: First adjustment occurs after five years, and then adjusts on a six month basis.
- 7/1 ARM: First adjustment takes place after seven years, and then adjusts on an annual basis.
- 10/1 ARM: First adjustment occurs after 10 years, and then adjusts on an annual basis.
- 15/15 ARM: First and only adjustment takes place after 15 years.
How can I make sense of the ARM rates?
The most popular ARM is 5/1 which has an introductory rate for five years and after this period, the interest rate can adjust once per year. Other common fixed rate periods for ARMs are 3/1 and 7/1.
If you have trouble interpreting the different rate periods for hybrid ARMs, keep this in mind: the first number represents how long the fixed interest-rate will be, and the second number represents how often the rate will adjust after the initial period. For example, for a 7/1 ARM, the initial fixed-rate period is 7 years and after this time, the rate will adjust on an annual basis.
You may also see some ARMs which are expressed as 2/28 or 3/27. When represented this way, the first number tells you how many years the initial fixed rate period will be and the second number tells you the number of years the adjustable rate period will be.
2. Hybrid adjustable rate mortgage (ARM)
A hybrid ARM is offered with an initial interest rate that is fixed for a certain period of time e.g a 5/1 ARM. After this specified time, the interest rate then adjusts to a new percentage based on the index and margin as specified by the lender. This rate adjustment normally occurs either annually or bi-annually.
Hybrid adjustable rate mortgages transfer a degree of interest rate risk from the lender to the borrow, so lenders typically make the initial interest rate of ARMs between 0.5% and 2% lower than standard mortgage products that have a 30-year term. For this reason, ARMs are beneficial for borrowers who are looking to take out a mortgage for around 5-10 years.
3. Fixed rate mortgage (FRM)
A fixed rate mortgage offers an interest rate that is fixed for the loan term. This means that both the payment amounts and the loan term are fixed. With an FRM, you can benefit from having the security and peace of mind in knowing what your payments will be, which will allow you to budget more effectively.
For example, if you took out a loan of $400,000 at 6.5% interest over a 30-year period, you would have standard monthly repayments of $2,528.27, which would remain unchanged throughout the life of the loan.
In the US, fixed rate mortgages are the most common mortgage product where an average fixed rate term ranges between 10, 15 and 30 years.
4. Interest-only mortgage
An interest-only mortgage is where the borrower only pays the interest portion of the loan over a typical term of 5 to 10 years. After this period, the principal balance of the mortgage is amortized for the remaining term. For example, if you had a 30-year mortgage and the first 15 years were interest-only, the principal balance would be amortized at the end of the first 15 years for the remaining 15 years of the term.
The benefit of interest-only mortgages is that early payments made during the interest-only period are generally lower than later payments, which gives you flexibility in the earlier years as you don’t have to make repayments towards the principal portion of the loan, which can lower your payments.
However, it’s important to realise that interest-only mortgages represent a higher risk for lenders and can therefore be subject to higher interest rates.
5. Negative amortization mortgage
Negative amortization occurs when the periodic payment does not cover the interest due for the respective loan period. The unpaid interest is then capitalized and accrued into the outstanding loan balance. This means that the principal amount of the loan increases by the amount of unpaid interest on a monthly basis.
6. Balloon payment mortgage
Although more common in commercial rather than residential real estate, balloon payment mortgages may come with a fixed or adjustable interest rate.
Balloon payment mortgages do not amortize over the term of the loan, which leaves a balance amount due at maturity. The name “balloon payment mortgage” is based on the large size of the final payment.
Interest rates vs APR
The annual percentage rate (APR) represents the effective interest rate that a borrower will pay on a mortgage, which takes into account ad hoc fees and transaction costs. The interest rate, on the other hand, is a fee on borrowed funds, which does not take into account transaction costs.
As a result, the APR is generally higher than the standard interest rate as the APR represents the “true cost” of the mortgage. The APR allows borrowers to better compare different mortgage products since many lenders have different fee structures.
Conforming vs non-conforming mortgages
If a mortgage satisfies the requirements set out by government-sponsored enterprises such as the Federal National Mortgage Association (also known as Fannie Mae) and Freddie Mac, it is considered to be a conforming mortgage.
One way to determine whether or not a mortgage product is conforming or non-conforming is the loan amount offered by the lender. Normally a mortgage with a loan amount less than $417,000 is considered to be a conforming product.
Be mindful that if your loan amount nears the conforming loan limit, you could significantly lower your mortgage rate by dropping your loan amount by just a couple of thousand dollars.
How can I apply for a mortgage?
If you’d like to apply for a mortgage, you’ll typically need to work with either an underwriter that works for a bank or a mortgage broker who can assess your borrowing needs to help you find the right loan.
When completing the application, and depending on whether it’s a low doc or full doc loan, you’ll generally need to provide:
- Personal details (identity and residential verification).
- Financial account details (any loans or debts you may have).
- A completed credit check.
- Evidence of income and employment.