It seems like these days, everyone is talking about interest rates. Whether it’s the APR on a credit card, the Federal Reserve adding and taking points, or the average cost of obtaining a home loan, interest rates are all over the news.
You’d be inclined to think that’s a bad thing, but is it really? Let’s take a closer look.
Interest rates are a financial tool through which a lender makes money in the act of redistributing and reallocating capital. Put simply, it is the price paid by the borrower for the opportunity to borrow the money. There has to be an incentive for the bank to lend the money, especially if they feel there is some risk that the money will not come back in a timely manner.
Interest rates have varied over time. In the 1970s, when home prices were significantly lower than anything we see today, interest rates averaged in the double digits, peaking at 16% during the stagflation crisis of the early 1980s.
As home prices increased through the years, the actual percentage rate declined, even though the amount paid steadily increased. During the peak of the pandemic, interest rates fell under 3.5% as the market recoiled from the shutdowns.
But all of this assumes that the loan structure is a 30 year fixed rate mortgage, which, although quite common, is not the only type of loan available. Let’s take a look at three other types of loans available from most conventional residential mortgage lenders.
Adjustable Rate Mortgages
Also known as an ARM, these mortgages have a fixed length of time, but carry an interest rate that adjusts due to market conditions. The advantage here is its flexibility; not being locked into a set market rate can allow individuals to purchase in adverse conditions knowing that their rate can change for the better in time. Conversely, these are less popular when rates are advantageous, as most buyers like to lock in a good rate while they have it. These types of loans often offer a lower initial monthly payment than other loans, especially fixed-rate mortgages.
A buydown loan allows the borrower to obtain a lower interest rate when taking out the loan. Buydowns typically involve the purchasing of points upfront to lower the rate; it is the initial payment that serves as the tradeoff for long-term savings. Usually, the seller pays into an escrow account that subsidizes the loan during the first few years. This results in a lower monthly payment on the mortgage. By lowering the payment, the borrower can more easily pay for the mortgage.
Interest Only Loans
As the name implies, the interest-only loan is a type of loan where the borrower only pays interest over some or all of the life of the loan, depending on the specifics. This results in lower than normal payments, at least to start. This is typically used in situations where the borrower intends to sell the property or otherwise pay off the loan in bulk, or in a situation where an investor is trying to maximize upfront cash flow potential.
As we all know, what goes up must come down. Rates will not hover at highs forever; market forces will stabilize and bring rates down to a more familiar territory. In the meantime, now is a great time to take advantage of lower prices and find the home of your dreams!