Monthly Myth: Low Rates Always Bring the Best Savings


Mortgage interest rate is an important part of your overall homeownership costs. But is a low rate always the best option? This month, we’ll examine the myth that interest rates are the most important part of your mortgage.

 

Mortgage Myth: Low Rates Always Bring the Best Savings

The myth makes perfect sense, and is certainly grounded in truth. All other factors aside, it is better and more affordable to have a low interest rate.

Consider what happens when you take a simple mortgage and increase the interest by only half a percentage point. Imagine you are purchasing a $500,000 home with a 5% downpayment ($25,000) and a 4% interest rate. Using our mortgage calculator, we see that this loan structure bring a monthly payment of $2,267.72.

What if we keep all other factors the same but decrease the interest rate to 3.5%? In this case, we see that the monthly payment is reduced to $2,132.62. With this small adjustment, the monthly payment was reduced by $135.10.

If we reduce the interest even further, we see (predictably) even greater savings. At 3% interest, the monthly payment drops to $2,002.62. This is a savings of $265 a month from where we started.

You can see why so many people get caught up with interest rate. The interest rate can have a major impact on the overall cost of your loan, especially as you move into loans of $750,000 or even $1 million.

But people have taken this fact and exaggerated it. This has led to the myth that borrowers should focus heavily on the interest rate; they should strive as hard as possible for a low interest rate and virtually ignore all other factors.

But is this myth true? Is the interest rate the only aspect that matters? Does a low rate always bring the best savings?

 

Mortgage Truth: Low Rates Are NOT Always the Best Option

The simple truth is that rates aren’t always the best option and they aren’t always as advertised. There are often hidden fees, lender fees, closing costs, and other factors worked into the loan that make up for the low interest rate. So while you will, technically speaking, get a low interest rate, you’ll be paying more on the loan, either upfront or rolled into the monthly payments.

Interest rate matters. We don’t want to give the impression that is doesn’t. But there are numerous factors that go into the affordability of your mortgage. Many of these are also directly connected to the interest rate; as one changes, so too will the interest.

 

Factors impacting your interest rate include:

 

Home Price

The total home price has an impact on your interest rate, especially if you have a larger home that requires a jumbo mortgage. Jumbo mortgages have more risk to the lender, and to compensate for this risk there is usually a higher interest rate. (This is not always the case, as some lenders can actually offer lower rates on jumbo loans in specific situations.)

 

Loan Amount

How much you borrow also has an impact. This is obviously related to home price, but it’s certainly not the same. Generally speaking, the larger your loan amount the more you will likely pay in interest, although if your other factors are strong you can often pay a low interest even on larger home loans.

 

Downpayment

Someone who brings a 20% downpayment, statistically speaking, is less of a risk to the lender than someone who brings a 5% downpayment. That person with a 5% downpayment, on the other hand, is less of a risk than someone with a 3.5% downpayment. You can see the trend: as your downpayment goes up, your risk as a borrower goes down. This means that lending institutions can offer lower interest rates to those with higher downpayments.

But there is an obvious issue here. Saving for a high downpayment can be difficult, and it can eliminate many of your savings. (Although the money isn’t lost, it’s just locked into the home.) The advantage of a high downpayment is a lower monthly payment and (potentially) a lower interest rate. However, you lose the chance to invest this money (called “lost opportunity” by financial experts and economists) and many people can’t afford the large downpayment to begin with.

 

Loan Term

From short-term loans to 40-year mortgages, this is a factor that has a major impact on your loan. The most common are 15-year mortgages and 30-year mortgages. Because you are paying interest for half the time, a 15-year mortgage is more affordable in the long run. (The total cost is much less.) But as an added bonus, a 15-year mortgage often brings a lower interest rate.

But your monthly payment will be much higher. Let’s look at our example of a $500,000 purchase with a 5% downpayment. At 30-years and 3.5% interest, the payment was $2,132.62. However, if we go with a 15-year term, the P&I payment increases to $3,395.69. That’s over $1,200 a month more! Yes, you will be free from payments in half the time, but it’s still a large cost from month to month.

 

Fixed or Adjusted Rate

A mortgage can have an interest rate that is locked in and never changes (fixed) or it can have a rate that changes monthly or annually (adjustable). This impacts your loan significantly, and different borrowers will find advantages from one or the other.

Fixed-rate mortgages are more common, but adjustable-rate mortgages often have starter periods where the rate is lower than usual. This introductory rate can be useful, but it won’t last so borrowers need to be ready for the increase. Also, with an adjustable rate you can benefit if rates decline but could pay more if they go higher.

 

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