Your Mortgage Interest Rate

Undeniably a big part of your mortgage package, interest rates are one aspect you don't have a whole lot of control over. Still, there are choices to be made.

This page:

  • Explains what interest rate decisions you face

  • Describes how rate and payment caps work

In the following pages we describe the elements of the mortgage package. The second section of the guide examines your credit capacity and how lenders look at the mortgage collateral.

Refer to the table of contents if you're looking for specific information.

How you can control your mortgage interest rate.

Interest rates tend to move in long cycles, with a gradual rise followed by a similar slow drop. Ideally, a prospective home buyer has the luxury of waiting for rates to fall and then quickly locking into the lowest possible rate.

Of course, most buyers are in the market regardless of what rates are doing. And the majority of them sign on to a fixed-rate mortgage.

When rates are relatively low, that's a good strategy. When rates are higher, the only way of securing a lower interest rate is to opt for an ARM.

Of course, no one can be sure what the interest rate market will do, and that risk is the ARM trade-off. Rates could keep rising in the future, bringing your monthly payment along with them.

But this risk becomes less of a factor if there's a good chance you are moving again sometime in the near future. If this is the case you can act on your hunches with a lot less risk, and allow yourself some flexibility as well.

Other than the type of mortgage (15-year FRM, 30-year FRM, or any number of ARMs) you choose, there is little you can do to change the rate you pay.

Make sure your credit is as clean as possible, and your down payment large enough. Paying discount points on the mortgage can earn you a much lower rate too. (And we discuss when paying discount points saves money next).

However, if you're looking at an ARM, please read the following very important information on rate caps first. Don't shop ARMs without it.

Interest rate caps

An ARM usually features some type of "cap" to protect the borrower from the possibility of skyrocketing interest rates. The most common of these caps are "rate caps." Most ARMs have annual rate caps, which limit the rise in interest rate per year (usually to 1-2%) and lifetime rate caps, which limit the rise in interest rate over the life of the mortgage (usually 6-8%).

While these are good to have, they're not really valuable because they're set so high. An 8% rise in interest rate over the life of a loan is still allowing quite a bit. They do offer the borrower some degree of protection, but don't commit to any mortgage package that might allow the monthly payments to grow so large you can't afford them.

Some lenders offer ARMs with payment caps, which limit the dollar amount by which your monthly payments can increase. However, this type of cap does not prevent the interest rate from increasing during that same time. This means that while your payments are low, the interest you're being charged is still high, and any extra money you owe is just being rolled into the principal.

This is called "negative amortization", and it can cause you to end up owing for even more than you borrowed!

You should never agree to an ARM that has payment caps instead of rate caps. They never help the borrower. No lender we recommend includes payment caps on any the mortgage products they offer.

On the next page, we look at discount points, an especially useful interest-rate-lowering tool for the long-term buyer.

Next: Discount points: Do they save you cash?

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