Lending companies charge a percentage rate or interest on the money they loan. You might think of it as a fee for borrowing their money to buy a home.
A fixed-rate mortgage ensures that your interest rate stays the same for the life of the loan. This can be good if interest rates rise, but not so good if they fall and you’re paying higher interest. With a fixed rate, your payments always remain the same, so it’s easy to see how much you’ll pay over the life of a loan.
See how interest rates impact monthly payments on a $210,000, 30-year, fixed-rate mortgage:
With adjustable-rate mortgages (ARMs, also called variable-interest-rate loans), the interest rate is generally fixed for a period of time, then adjusts periodically based on changing market interest rates. As a result, your loan payments may decrease or increase. Most ARMs come with caps on periodic rate adjustments and lifetime increases.
Interest Rates and Affordability
Interest rates impact monthly mortgage payments, which in turn impact just how much home you’re able to afford. Let’s say you’re looking to buy a $210,000 home, put a 20% down payment on a 30-year fixed-rate loan and spend $850 on your monthly mortgage payments.
|Total Loan Amount: $168,000|
Interest Rate: 4%
Monthly Mortgage Payment: $802
Interest Rate: 6.5%
Monthly Mortgage Payment: $1,061
If the market is favorable and interest rates are low—say 4%—your monthly payments remain well within your budget. If rates are higher—in this case, 6.5%—your monthly payments jump by more than $250. While you may be able to refinance to a lower rate if rates drop down the road, the home is squarely out of reach for the time being.
In order to remain within budget on your monthly payments with interest rates at 6.5%, you’d need to lower your total loan amount from $168,000 to $133,000 by either putting more money down on this home or opting for a less expensive one.
Your Interest Rate
Lenders use several factors to determine how much interest to charge on a loan. These include:
Credit score: Also called a FICO score, a credit score represents your credit risk. It takes into consideration your total outstanding debt, your debt payment history, length of credit history and the types of loans and other debt you carry. The higher your FICO score, the better your chances of landing a lower interest rate. Many lenders require a score of at least 700.
Debt-to-income (DTI) ratio: Lenders measure your ability to make monthly payments and repay debt by comparing the amount of debt you carry each month with how much income you bring in each month. A low DTI often equates to a lower interest rate.
Length of loan (loan term): A fixed-rate mortgage ensures your interest rate stays the same for the life of the loan. These loans can come in 10-, 15-, 20- and 30-year terms. A longer-term loan often comes with a higher interest rate, but lower monthly payments because you spread out the payments over a longer time period. With a shorter, 15-year loan, your monthly payments will be higher, but the interest rate will be lower.
Market conditions: The U.S. Federal Reserve (the Fed) has a big influence on market conditions, which affect interest rates. When the Fed buys more securities, like bonds and certificates of deposits, credit unions and banks have more cash on hand. With more available money to lend, credit unions and banks can lower interest rates. On the flip side, when the Fed sells securities, banks have less money at their disposal for lending. This forces a rise in interest rates.
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