Rate shoppers naturally gravitate toward the lowest quotes, but a lower rate can lead to financial trouble if you don’t understand your loan terms. It’s important to know the relationship between rates and fixed terms so you can determine when it’s appropriate to use a shorter loan term instead of a longer one.
Why rates are higher for longer-term loans
A 30-year fixed mortgage rate is higher than a five-year adjustable rate mortgage (ARM) rate because a financial institution is taking more risk to lend you the money for a longer period of time.
The reason for this goes to the root concept of how banks operate. A bank’s business model is to ensure that interest they collect on loans exceeds interest they must pay out on deposits.
Interest that banks must pay you on deposits rises as the economy expands, and falls as the economy contracts over time. It’s easier for banks to manage this interest rate risk in the short term.
For example, interest rates paid on checking and savings deposits are very low because you’re free to withdraw your money any time, while rates paid on certificate of deposit (CD) accounts are slightly higher because the bank requires you to keep those funds deposited for periods of one month to five years.
Because banks know their expenses on deposits for periods up to five years, they know how to price mortgage loans up to five years. Today, many banks would pay you about 2.25 percent on a five-year CD, and they’d charge you about 3.25 percent for a five-year ARM.
But if you were getting a 30-year fixed loan, they might charge you about 3.875 percent — although these rates fluctuate. This rate is higher in order to compensate a bank for the interest rate risk they’re taking. Rates they must pay on deposits might be much higher during that 30-year period as the economy fluctuates, but your 3.875-percent mortgage rate is guaranteed.
read more: http://www.king5.com/story/news/features/2015/02/25/adjustable-rate-mortgages-its-all-about-timing/23993903/
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