In the late 1970’s mortgage rates soared. People buying houses saw rates up to 17% in some markets. It made buying a house unaffordable for most people. Although rates have been rising, no one expects to see those bad old days. Interest rates rise when inflation flares and, other than energy costs, inflation has been kept under control.
The reason that mortgage rates are tied to inflation is that the lenders want to make sure that their investments outperform inflation. So, for example, if you get a 30 year mortgage at say 7% but 10 years into the loan the inflation rate hits 14%, the lender is actually losing 7% a year on the investment. This is one reason that adjustable rates have become so popular.
Whenever a lending institution funds a mortgage, they are taking a risk. They are betting that you’ll be able to pay back the mortgage, but if it’s a fixed rate loan, they’re also betting that the interest rate will outpace inflation. Trying to predict something like inflation over 30 years is notoriously difficult.
Another factor that can affect interest rates is how much debt everyone else has. If the federal government takes on a lot of debt, then the amount that’s left for everyone else to borrow is less and the interest rates go up. If consumers are charging on their credit cards, then investors are going to be looking for higher returns and this also makes the rates go up.
Lenders don’t want to take on all the risk in a loan. Interest rates on 15-year loans are generally lower than on 30-year loans. Adjustable rate loans have lower initial rates than fixed rate loans because lenders prefer these types of loans.
When you take out an adjustable rate loan, you’re sharing some of the risk with the lender. These loans usually have caps to limit the risk you are taking. Generally there are two types of caps, annual and a maximum.
The annual cap prevents a large jump in one year. If, for example, interest rates hiked 2% in one year but the annual cap on your adjustable rate is 1%, then your rate would only increase 1% for that year.
The maximum cap is the highest that your rate will ever go. This is an important consideration because interest rates are at historical lows. Most analysts predict that rates will rise over the next few years.
Just a few points difference can mean hundreds of dollars in monthly payments. For example, if you have a fixed rate, 30-year mortgage with an interest rate of 5.25% your monthly payment would be $1,104. If you financed the same amount, for the same term but the interest rate was 6.25%, your monthly payment would be $1,231.
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