Mortgage Rate: Definition & Types

Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and a PhD in Higher Education Administration.

During the exciting process of buying a home, most buyers need to also decide on what type of mortgage they want. In this lesson, we'll discuss the most popular types of mortgages and some of the benefits and costs of each.

Types of Mortgages

As Laura and Russell prepare to buy their first home, they start looking at mortgage information. Laura does an internet search and suddenly is overwhelmed with terms like fixed-rate mortgages, adjustable-rate mortgages (or ARMs), and interest-only with balloon payment mortgages. All of a sudden, Russell and Laura feel a bit unprepared.

At first, the mortgage loan was a pretty simple concept: if the buyer pays 20% of the price of the home, a bank will lend them the other 80%, and the buyer can pay the bank back, with interest, a certain percentage of the loan added to what is owed for the privilege of borrowing the money, over the next 30 years. However, as the mortgage loan became more popular, and necessary, banks invented new types of mortgages. In this lesson, we'll learn about the three main types of loans: fixed-rate, adjustable-rate, and interest-only.

Fixed-rate Mortgages

A fixed-rate mortgage is the most basic type of mortgage loan. When the loan is made, whatever interest rate the bank is offering is the rate paid through the entire life of the loan. For example, if the fixed-rate for a 30-year loan is 4.5%, then the payments are based on 360 payments (30 years x 12 months per year) at 4.5%, and that payment stays the same for 30 years.

Fixed-rates vary based on the economy, the credit profile of the borrower, and the length of the loan. Buyers with excellent credit get lower rates than buyers with lower credits, and loans with shorter terms, for example 15-year loans, have lower rates than 30-year loans.

The primary advantage of a fixed-rate loan for the buyer is that they know exactly what their payment will be every month of their loan. For the banks, they also know what to expect as far as the return they will make on that loan. It's very predictable, and generally, people like predictability.

Adjustable-rate Mortgages

A few years after mortgage loans became popular, interest rates became very high. In the early-1980s, a fixed-rate mortgage could be as high as 16% - 20%, even for buyers with good credit. That was a sting to the mortgage industry because many people couldn't afford to take out loans with such high interest rates. So, banks introduced adjustable-rate mortgages (ARMs).

Adjustable-rate mortgages change based on some benchmark interest rate, such as the federal funds rate, a rate set by the Federal Reserve that banks use when they borrow money from one another. To entice borrowers to accept an adjustable-rate mortgage, banks would offer introductory rates at a discount. For example, if fixed-rate mortgages for a 30-year loan was 6%, an adjustable-rate loan might start at 3%. On a $150,000 loan, that is a $300 difference in the loan payment.

Of course, there is a catch. That 3% was the introductory rate. Adjustable-rate mortgages are named with numbers, such as a '5/1 ARM.' That means the introductory rate will last for 5 years (the first number), and then will be reset every 1 year (the second number). The paperwork for an adjustable-rate mortgage will state what benchmark is used and the amount above the benchmark that the new rate will be.

For example, that 5/1 ARM might say that each year, the rate is adjusted to the federal funds rate + 1.5%. So, for five years the rate is 3%, but then at 5 years, it becomes whatever the federal funds rate is, plus 1.5%. That, obviously, is a little bit of a gamble by the borrower. If rates go down and the federal funds rate is .5%, their new rate is 2%, decreasing their payment by $100. But, if rates go up, and the federal funds rate is 4%, the borrower's new rate is 5.5%, increasing their monthly payment by $250.

The benefits of these loans are obviously the lower rates, at least in the beginning. But, what happens after that is anyone's guess. The housing crisis that started in 2006 was in large part due to people having taken out loans years earlier with low introductory rates, and then when the rates went up, they could no longer afford their mortgage payments. Adjustable-rate mortgages should be considered very carefully.

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