Mortgage Rates

Homes are expensive and most people do not have the cash on hand to buy one outright. Even when they do, it is not necessarily the best idea to tie up all of your money in a piece of property. For that reason, when buying a home, most people take out a mortgage, a financial arrangement in which a financial institution loans the buyer the money needed to buy the house and the buyer agrees to repay the loan, both principal and interest, according to a repayment schedule over an agreed-upon length of time. The house itself is used as collateral to guarantee the loan, meaning the financial institution takes possession of the house if the home buyer does not fulfill his or her repayment obligations.

Other than the length of time the buyer has to repay to loan (its duration), the main way that mortgages differ from one another is through the mortgage rate, the percentage of interest that the financial institution receives in exchange for loaning the money. The mortgage rate is set by the financial institution based on a number of factors – the current rate of interest that the financial institution pays on the money it borrows, how risky its analysts think it is to make a loan of that amount and duration for that piece of property, and how risky they think it is to loan money to that particular home buyer.

When you go around to different financial institutions “shopping” for a mortgage, you will see that rates will vary for mortgages with otherwise identical terms. This is because financial institutions come to different conclusions about the riskiness of each loan. Also, because of their own situations and attitudes toward risk, financial institutions can be more liberal or more conservative about how much interest they require in exchange for making the loan.

But the biggest difference-maker in mortgage rates is whether the mortgage has a fixed rate vs. a floating/adjustable rate. Fixed rate mortgages give the home buyer the security of knowing the exact amount of all payments over the course of the mortgage term. The fixed rate acts as a ceiling on their interest payments. Even if market changes cause the mortgage rate to go up (meaning that financial institutions will only make loans in exchange for more interest), the home buyer with a fixed rate mortgage still pays what was originally agreed upon. If market changes cause the mortgage rate to go down, the home owner can “refinance” – taking out a new mortgage at the lower interest rate and using that money to pay off the original mortgage. To compensate for this, financial institutions usually charge a penalty for early repayment.

Unlike fixed rate mortgages, where financial institutions assume all of the risk of market changes, floating/adjustable rate mortgages pass this risk on to the home buyer. The interest rate is adjusted from payment to payment based on a collection of market measures called an index, so the financial institution always collects the amount of interest it would need to be willing to make the same loan in today’s market. The home buyer, on the other hand, has no way to predict or plan for what their future payments are going to be.

Given the home buyer’s preference for fixed rate mortgages, financial institutions charge a premium for them, in the form of a higher mortgage rate. In other words, if the financial institution is going to assume the risk involved in a fixed rate mortgage, earning less interest on the loan than it “should” when the market changes, then it will require a higher interest rate from the beginning. Somewhere in the middle you can also find split rate mortgages - hybrids of these two mortgage types. The rate is fixed for some amount or duration of the mortgage, and floating/adjustable for the rest.