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A Brief Guide to Mortgage Interest Rates

February 6th, 2015 12:38 PM by Jackie A. Graves


When a lender loans you money to buy a home, it expects to make money for the service. It does this by charging interest on the loan. The higher the interest rate, the higher your monthly payments and the higher the loan’s total cost.

Figuring out the best interest rate for your mortgage can be tricky, but it’s not impossible. Here’s a rundown of how it works.

Adjustable or fixed rate?

You need to consider whether the interest rate you are quoted will remain the same for the life of the loan (known as a fixed-rate mortgage, or FRM) or change over time (known as an adjustable-rate mortgage, or ARM).

Adjustable rates will typically start out lower than fixed rates during an introductory period before adjusting to a higher rate. How many times the rate can adjust depends on the loan—it might happen once a year.

Because it’s hard to predict which way interest rates will go over the long term, there’s some risk involved with an adjustable rate. However, if you don’t want to keep the home for a long time, the low introductory rates for ARMs can be beneficial. Those who plan to see out the life of their loan may prefer an FRM.

Margin and index

An interest rate is made up of two parts: the margin and the index. The margin is the lender’s profit margin, which can vary from lender to lender and may be negotiable. The index is a rate set by economic factors.

With an ARM, the margin stays fixed but the index fluctuates. With an FRM, both stay fixed.

Discount points

You can lower your rate by buying discount points at closing. Buying one point typically equals knocking 0.25% off the interest rate. One point costs 1% of the total loan amount. So if you buy one point off a $200,000 loan with a 3.5% interest rate, you pay $2,000 for a reduced interest rate of 3.25%.

Before doing this, know how many months it will take you to recoup what you paid for the point. If it’s going to take six years to break even but you plan to sell in five, you’ll lose money.

Prepayment penalty option

Some lenders may offer you a slightly lower interest rate for a prepayment penalty agreement. The prepayment penalty is what it sounds like: If you pay off your mortgage too early, you have to pay a hefty fee.

If the prepayment penalty period is short, say, within a few years, and you don’t plan on refinancing or selling, it’s probably worth it. But if you’re looking at a penalty period that stretches longer into the loan’s life, it’s probably not worth it.

Get multiple quotes

If you want to find the best rate, you’ll need to know what competing lenders are offering. Get several quotes from different lenders. Make sure you get the good-faith estimate for each offer so that you can compare them.

Locking in or floating down

If you’re going with an FRM or a mortgage with a fixed-rate period (like a hybrid ARM), you have to decide when to lock in the interest rate. When you do, the lender guarantees the rate for a certain number of days. The longer the guarantee period, the more it costs.

You can also go for a float-down option, which allows you to get a lower interest rate if rates go down. The terms, conditions, and costs of this option vary from lender to lender.

By: Craig Donofrio   |  Updated from an earlier version by Laura Sherman

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Posted by Jackie A. Graves on February 6th, 2015 12:38 PM


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