Understanding how mortgage interest rates work
When most people buy a house they need to borrow money for some part of the purchase price of the house. So, let's say that we have a house right over here and the purchase price is $200, $200,000. And I want to buy this house and I've saved up $40,000. I have saved up $40,000. So, this is my savings, and so I will use this as a down payment but I still need to borrow the rest of the money in order to get to $200,000, so I'm going to have to get, I'm going to have to get the, the balance, the $160,000 as, as a loan, as a loan. And the type of loan that people get or that they usually get to buy a house is called a mortgage, mortgage. And a mortgage is really just a loan where if you don't pay the loan off the person that you borrowed the money from gets the house.
So, another way to think about it is it's a loan that is secured by the house until you pay off the loan. When you pay off the loan it is your house to keep. And at any point if you don't pay it the bank can come and take the house and that is called a foreclosure. Now, what I want to focus on in this video is the types of mortgage loans you will typically see and give you at least the beginning of an understanding of how to understand what these different types of loans mean.
So, in all of these scenarios, let's just assume that I'm in the market to borrow $160,000 for this house I'm about to buy. So, if you look at any financial website or, or any of the major even search, web portals, you, they'll give you quotes for mortgage rates and you'll see something like this, I made these numbers really simple, normally you'll have some decimals here, 5.25 percent, 4.18 percent. I made these numbers a little bit simpler just, just to make them simpler. So, these are the typical types of mortgage you will see but if you contact a mortgage broker they'll have many, many more types of, more exotic types but these are the most common, this is what we'll cover in this video and hopefully they'll give you a sense of what the other types of mortgage are like.
A 30-year fixed mortgage means that your payment and your interest rate are fixed over 30 years and over the course of those 30 years you will pay off your loan. So, in this situation, so let me, so this is a 30, let me write it over here, let's think about a 30-year fixed, 30-year fixed mortgage. What will happen is you will have a fixed, you will have a fixed mortgage payment every month. So, and I'll draw a little bar graph to show the size of your payment. You'll see why I'm doing that in a second so let me just draw a little bit of a graph here. So, each of these blocks represent your monthly payment for that month and I'm just going to make up the number. Let's say it is $2,000. I actually haven't figured out the math of what is the exact payment for a 30 year fixed with a five percent interest rate for $160,000 but let's just say for the sake of simplicity let's say it's $2,000 a month. So, that this height right over here, we make it, make it like this. So, that this is $2,000 a month, $2,000.
This is month one, then you will pay $2,000 in month two, so on and so forth all the way, if you have 30-years times 12 months you're going to get all the way to month 360 and you are going
to, and that is going to be your last payment through, month 360 is the last payment in year 30 and you would have paid off your loan. The interesting thing here is, in the first month, since you've borrowed so much from the bank, you've borrowed $160,000, the interest that you have to pay on it is going to be pretty large. So, most of the initial payments are going to be interest. So, I'm going to do the interest in this magenta color, so in that first payment, that's not magenta, this is magenta. In that first payment it's going to be mostly interest. And you're going to pay a little bit off of the actual loan. So, that right there is your principal payment.
So, let's say after that first month the principal part of that $2,000 is, and I'm just making up numbers for the sake of simplicity, let's say that that is $200 and the interest portion, the interest portion is $1,800. I'm not actually working it through with these assumptions, you don't even have to assume that it's a $160,000 loan. But the general idea here is after this first month you would have paid $200 off of your loan. So, if it was $160,000 loan, after that first month you don't owe $160,000 minus $2,000 because $1,800 of that was interest. You now owe $160,000 minus $200.
So, you now owe $159,000, uh, $159,800. And so, in the next period your interest is going to be a little bit lower. It's going to be just a little bit lower and your principal, since you're paying the same fixed payment of $2,000 every month is going to be a little bit higher, maybe it's going to be in the next month, something slightly higher, I don't know, $202. And you keep going like that and the math works out and you figure out the payment so that by that last payment, by that last payment you're paying very little interest, you're paying very little interest and most of that last payment is principal. It's actually being used for the loan and then after that last payment the loan is paid off. And this will happen over 30 years, this is a 30-year term.
A 15-year fixed is the same exact idea except instead of going from, instead of this being, instead of it taking 30 years to pay off the loan you're going to do it off over 15 years. So, instead of it being 360 months in the 15-year case it is going to be, it is going to be 180 months. And because of that your payment for the same loan amount is going to be higher every month because you're paying it off quicker. You're paying it off in fewer months. Instead of $2,000 a month maybe it is something like $2,800, $2,800 a month for the 15 year case. You're paying it off quicker.
The 5/1 ARM case, and you'll see, there are many types of ARMs and I'm going to explain to you in a second what an ARM is but the 5/1 is the most typical and I'll explain what that means in a second. ARM means, ARM means adjustable-rate mortgage, adjustable, adjustable-rate mortgage. And as you see in, in these situations we had the word fixed and they're, they're called fixed because the interest rate was fixed. Whatever your, whatever your remaining loan balance was you paid the same fixed amount of interest on, for the next period. So, for this 30-year fixed we are being quoted a five percent fixed rate over the next 30 years will not change,
for the 15-year we're quoted a four percent fixed rate. For the ARM the rate can change.
When someone tells you about a 5/1 ARM they're actually talking about something called a hybrid ARM. But the general idea behind an adjustable-rate mortgage is that amount of interest you pay on your remaining balance will change and it will change according to some index. The most typical types of adjustable-rate mortgages are things like this hybrid ARM, so this is a hybrid. And a hybrid, it's viewed as a mixture of two things or a combination of two things. And what a hybrid adjustable rate mortgage is, is it has a fixed rate for some period of time, in this case it's a
fixed rate for, it is a fixed rate for five years and then the interest rate can change once a year after that, or every one year after that and that's what this right over here is telling you.
So, in case of, in the case of an adjustable rate mortgage your payment might look something like this. And I'm, I'm just making up numbers for simplicity, just to give you the flavor of what it might look like. So, months, in the case of a 5/1 your first five years are fixed. So, your first five years, so month one, it's going to look like that. Month two is going to look like that, you go all the way to month 60, which is the last month of the five years and it's going to look like that. So, that's one, that's month two, that is month 60, this is the course of five years.
This is over the course of five years, and over the course of five years it's a, the, the, the idea is fairly similar, you're going to pay some part of this is going to be, some part of this is going to be interest and the remainder is going to actually be used to pay down the loan. And each month you're going to pay down a little bit more of the loan and you're going to have to pay a little less in interest, if you've got a little bit bigger, and you're going to have to pay a little bit less in interest, and you're going to have to pay a little bit less in interest because you've, you have less remaining on your loan and by month, but by year five or month 60 you still haven't paid your loan off, so maybe the interest is right over here, maybe the interest is right over there, it actually might be higher than that, I don't want to be too exact, but maybe your interest is going to be right over here. And then, and then this is what you're paying down from the loan.
For a hybrid adjustable rate mortgage, after that five-year period the bank can now change the interest rate. And the interest rate is going to be dependent on some kind of underlying thing that everyone is paying attention to. And so that underlying thing increases in interest. So, in this five, in this 5/1 ARM it starts off at a three percent interest. If, because of this thing that we're paying attention to and I'll, I'll talk more about that in a second, interest rates all of a sudden go up, then let's say they go up a lot, then all of a sudden your payment could increase, your payment could increase. ‘Cause the general idea behind a 5/1 ARM is that you are still going to pay it off in 30 years. So, they typically, I should say, have a 30-year term.
So, if you just stick with this loan, you never try to borrow other money to replace this loan, which is called a refinance, if you just stick with this loan it will take you 30 years to pay it off but after the first five years the amount of interest you pay might actually change and so your payment might actually change. So, if the interest rate goes up, if the interest rate goes up, all of a sudden you might have to pay a lot more interest, all of a sudden, in month 61 or in year six, in year six, in year six. Let me do that in, do that in, that part in that same blue color. And that for year six, since this is a 5/1 ARM, they can't change the interest rate again until year seven, so you'll pay this constant amount until year seven and then they can change the rate again. And there usually are some caps on how much they can change the rate each year or how much they can change the rate in total. But it is a little bit riskier because you really don't know what your payment might be in year six or year seven, especially if interest rates go up a lot.
Now, you might be asking, what determines what that new interest rate is in after the five years? And they usually pick some type of index, the most typical are, is especially in the United States, Treasury Securities, so they'll look at the 10-year Treasury, uh, interest rate that the, essentially the government has to pay when it borrows money and they'll usually take some premium over this. So, if the one year or in the 10-year Treasury is at two percent, the bank might put in your, in your loan documents that after the initial five year fixed period you will pay ten year Treasury rate plus maybe you'll pay that plus one percent. So, you start off paying the three percent, that's fixed, even if the Treasury does all sorts of crazy things even if it goes up to five percent, you're just going to keep paying the three percent for the first five years. But then in that sixth year, let's say that, let me write it right over here, let's say that in year six the Treasury, the Treasury Security rate now has bumped up to four percent. Then, by contract, by what's in your loan document you're going to have to pay that plus one percent.
So, now your mortgage is going to reset to have a five percent rate, have a higher rate. You might get lucky, though. Maybe your, maybe the Treasury rate goes down, maybe it goes to one percent. And then your mortgage rate would actually be one percent plus one percent so it could actually go down to two percent. But the general idea is, is that that's a little riskier because you really don't know how predictable that payment is going to be. And if you look at most, uh, you know, most times if you look at, uh, quoted interest rates you'll see that the 30-year fixed rate is higher than the 15-year fixed rate, which is higher than the adjustable rate. And that's because the bank, there's a couple of different forms of risk but the bank is taking the least amount of risk on the adjustable rate mortgage and taking the most risks on the 30-year fixed. And the biggest risk here, there's the risk that you don't pay it off, but that's why they like to see a down payment, because they can get the house back, and hopefully the house doesn't devalue by more than your down payment, but even more than that there's an interest rate risk.
Because what happens if the bank lends you money, lends you a big chunk of money at five percent and that interest rates go up to six percent, seven percent, what if they go up to ten percent? What if the bank's borrowing cost, the amount of money the bank has to pay people to borrow money, goes up to ten percent? Then it will be taking a loss on your loan. So, they, they, and, and they're fixing it for so long that's why they want to make up for some of that risk by charging you higher interest. A 15-year loan, a little bit less risk. So, they'll have a little bit lower interest. A 5/1 ARM, even lower risk, they're only fixed for five years and then after that they can float, this will float with the prevailing interest rate on an annual basis.
So, hopefully that gives you a little bit of a primer of, of mortgage interest rates but I want to, I want to really, you know, make sure that you don't, you, just, just, this video isn't all you need to, to take out a loan. Uh, it's super important to read the fine details on, on what's happening with that loan, especially if you're buying something more, if you're taking out a more exotic loan like an adjustable rate mortgage or an interest only loan or an option, uh, uh, an option ARM or any of the, of those more exotic things.Source: www.bettermoneyhabits.com