Intro to Mortgage – ARM, Rates, APR, Points, Credits

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Chances are, if you’re reading this article, you’re thinking of getting a mortgage to finance your home – and are very confused by how to understand and shop for mortgage rates. Here’s a quick guide to understand the jargon, so that you can be more informed and navigate the process easily.

Rate Types

Fixed-rate Mortgage (15 vs 30 years)

A fixed-rate mortgage is one that doesn’t change for the entirety of the duration of your loan. When you sign up at a certain rate, that rate will remain the same throughout your repayment period – and so will your monthly payment amount. No surprises – you get what you signed up for.

Fixed-rates are commonly 15 years or 30 years long (though sometimes you may find 10 and 20-year loans). As you would assume, the length of the loan suggests the duration for which you’ll be making your monthly mortgage payments – the longer the loan terms, the longer you’ll be making payments.

Of course, the benefits of a longer loan term is lower monthly payments, meaning that you can afford a more expensive house earlier. The trade-off is that the total amount you’re going to end up paying will be higher for the longer-term loan because more interest accrues. You’ll essentially be paying a higher price for a home to buy it earlier. Whether that is worth it for you is up to you to decide, perhaps with your financial advisor.

Adjustable-rate Mortgage (ARM)

Sometimes referred to as a variable rate mortgage, an ARM functions differently from a fixed-rate mortgage. Whereas with a fixed-rate mortgage, you can expect every one of your monthly payments to be the same as the first month, this no longer stands true with an ARM.

The nomenclature for an ARM is usually:

*Number of years for which the initial rate will stand true* / *Number of years after which the rate will change again*

For example, you’ll see ARMs commonly as 5/1 or 7/1 or 10/1. This means that the rate at which you sign up will stand true for the first 5, 7 and 10 years respectively, and every year after that, the rates will adjust to fit the market standard.

The benefit of ARMs is that they tend to offer lower initial rates than fixed-rates. As you would assume, from the same lender, a 7/1 ARM would have better initial rates than a 10/1 ARM, and the 5/1 ARM would have the best initial rates of them all. Over time, after the initial rate resets, your rates may (and usually do tend to) go higher than even a fixed rate, which is the drawback to ARMs.

Most people opt for fixed-rates because it is the safer option, and one that is easier to budget for, but most people also refinance or sell their home within 10 years, so perhaps there is merit in considering an ARM.

This is however dependent on the market, and at times, fixed-rate mortgages WILL be cheaper than initial ARM terms, at which point there may be little reason to choose an ARM.

Interest Rates vs Annual Percentage Rate (APR)

An interest rate (or simply, rate) is the cost of borrowing a sum of money from a lender. Mathematically, a compound interest rate is used to determine how much you are charged for borrowing that sum of money. For example, if you borrow $1M from a bank, and the rate is 3.5%, assuming you pay none of it back by the end of the first year, you’ll now owe the bank $1.035M. Assuming you pay none of it back even by the end of the second year, you’ll now owe the bank $1.035 + $(1.035 * 3.5%) = $1.071M. Note that your interest compounds every year.

Of course, the math is never this simple, and you would be required to pay monthly mortgage payments. The method that lenders split your payments between whether you’re paying off your interest first or the borrowed amount, is also complicated, so it’s simplest to use a mortgage calculator to understand your payments.

An APR is similar to an interest rate, except it acts as a more general measure of the appreciation of capital you owe the lender after including all other fees (such as mortgage insurance if your down payment is less than 20%, most closing costs, discount points, and loan origination fees). 

Essentially, an interest rate is a pure way of comparing how much the lender is charging you to borrow a sum of money, and the APR is a way to compare how much lenders are charging on top of the interest rate to provide you a loan.

Points and Credits

You can think of points and credits as means to sway your APR (and therefore your monthly payments). Remember how, in the previous section, we talked about varying closing costs affecting your APR? When you’re able and willing to pay more of it upfront (during closing), your APR will be lower (and closer to your interest rate). When you’re unable or unwilling to pay much of your closing costs up front, you’ll add it to the capital that is borrowed from the bank, increasing your APR.

When you pay more upfront, it’s referred to as points, and when you’re choosing to pay less upfront, it’s referred to as credit (similar to a credit card, where you’re getting a lender to pay upfront for you).

While it may seem intuitive to always pay more upfront so that you can save in the long term if you plan on selling or refinancing shortly after purchase, remember that you won’t end up facing the brunt of the larger long term payments if you choose for more credits. Therefore it might be beneficial to weigh your financial benefits when shopping around for points and credits alongside your rates.

As with all other aspects of financial literacy, staying informed and educated about your options can give you a strong head start when optimizing your expenditure, especially when considering a large purchase like a home.