Mortgage Interest Rates | Housing | Finance & Capital Markets | Khan Academy

ruticker 02.03.2025 23:23:33

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When most people buy a house, they need to borrow money for some part of the purchase price of the house. So, let's say that we have a house right over here, and the purchase price is **$200,000**. I want to buy this house, and I've saved up **$40,000**. I have saved up **$40,000**, so this is my savings, and I will use this as a down payment. But I still need to borrow the rest of the money in order to get to **$200,000**. So, I'm going to have to get the balance, **$160,000**, as a loan. The type of loan that people usually get to buy a house is called a **mortgage**. A mortgage is really just a loan where, if you don't pay the loan off, the person that you borrowed the money from gets the house. Another way to think about it is it's a loan that is secured by the house. Until you pay off the loan, when you pay off the loan, it is your house to keep. At any point, if you don't pay it, the bank can come and take the house, and that is called a **foreclosure**. Now, what I want to focus on in this video is the types of mortgage loans you will typically see and give you at least the beginning of an understanding of how to understand what these different types of loans mean. So, in all of these scenarios, let's just assume that I'm in the market to borrow **$160,000** for this house I'm about to buy. If you look at any financial website or any of the major search web portals, they'll give you quotes for mortgage rates, and you'll see something like this. I made these numbers really simple; normally, you'll have some decimals here: **5.25%**, **4.18%**. I mean, these numbers are a little bit simpler just to make them simpler. So, these are the typical types of mortgages you will see. But if you contact a mortgage broker, they'll have many, many more types—more exotic types—but these are the most common. This is what we'll cover in this video, and hopefully, they'll give you a sense of what the other types of mortgage are like. A **30-year fixed mortgage** means that your payment and your interest rate are fixed over **30 years**, and over the course of those **30 years**, you will pay off your loan. So, in this situation, let me write it over here. So, let's think about a **30-year fixed mortgage**. What will happen is you will have a fixed mortgage payment every month. I'll draw a little bar graph to show the size of your payment. You'll see why I'm doing that in a second. So, let me just draw a little bit of a graph here. Each of these blocks represents your monthly payment for that month, and I'm just going to make up the number. Let's say it is **$2,000**. I actually haven't figured out the math of what is the exact payment for a **30-year fixed** with the **5%** interest rate for **$160,000**, but let's just say for the sake of simplicity, let's say it's **$2,000** a month. So, this height right over here—let me make it like this—this is **$2,000 a month**. **$2,000** this is month **1**. Then you will pay **$2,000** in month **2**, so on and so forth. All the way, if you have **30 years** times **12 months**, you're going to get all the way to month **360**, and that is going to be your last payment. Month **360** is the last payment in year **30**, and you would have paid off your loan. The interesting thing here is in the first month, since you've borrowed so much from the bank—**$160,000**—the interest that you have to pay on it is going to be pretty large. So, most of the initial payments are going to be interest. I'm going to do the interest in this magenta color. So, in that first payment, it's going to be mostly interest, and you're going to pay a little bit off of the actual loan. So, let's say after that first month, the principal part of that **$2,000** is—and I'm just making up numbers for the sake of simplicity—let's say that that is **$200**, and the interest portion is **$1,800**. I'm not actually working it through with these assumptions; you don't even have to assume that it's a **$160,000** loan. But the general idea here is after this first month, you would have paid **$200** off of your loan. So, if it was a **$160,000** loan, after that first month, you don't owe **$160,000** minus **$2000** because **$1800** of that was interest. You now owe **$160,000 - $200**, so you now owe **$159,800**. In the next period, your interest is going to be a little bit lower. It's going to be just a little bit lower, and your principal, since you're staying the same fixed payment of **$2,000** every month, is going to be a little bit higher. Maybe it's going to be in the next month something slightly higher, I don't know, **$202**. You keep going like that, and the math works out. They figure out the payment so that by that last payment, you're paying very little interest. You're paying very little interest, and most of that last payment is principal. It's actually being used for the loan, and then after that last payment, the loan is paid off. This will happen over **thirty years**. A **15-year fixed** is the same exact idea, except instead of it taking **30 years** to pay off the loan, you're going to do it over **15 years**. So, instead of it being **360 months**, in the **15-year** case, it is going to be **180 months**. Because of that, your payment for the same loan amount is going to be higher every month because you're paying it off quicker. You're paying it off in fewer months. Instead of **$2,000** a month, maybe it is something like **$2,800** a month for the **15-year** case. You're paying it off quicker. The **5/1 ARM** case—and you'll see, and there are many types of ARMs, and I'll explain to you in a second what an ARM is—but the **5/1** is the most typical, and I'll explain what that means in a second. ARM means **Adjustable Rate Mortgage**. As you see in these situations, we had the word **fixed**, and they're called fixed because the interest rate was fixed. Whatever your remaining loan balance was, you paid the same fixed amount of interest out for the next period. So, for this **30-year fixed**, we are being quoted a **5%** fixed rate over the next **30 years**. It will not change. For the **15-year**, we're quoted a **4%** fixed rate. For the ARM, the rate can change. When someone tells you about a **5/1 ARM**, they're actually talking about something called a **hybrid ARM**. But the general idea behind an adjustable rate mortgage is the amount of interest you pay on your remaining balance will change and will change according to some index. The most typical types of adjustable rate mortgages are things like this **hybrid ARM**. A hybrid is viewed as a mixture of two things or a combination of two things. What a hybrid adjustable rate mortgage is, is it has a fixed rate for some period of time—in this case, it's a fixed rate for **five years**, and then the interest rate can change once a year after that. That's what this right over here is telling you. In the case of an adjustable rate mortgage, your payment might look something like this, and I'll just make up numbers for simplicity just to give you the flavor of what it might look like. So, in the case of a **5/1**, your first five years are fixed. So, your first five years—month **1** it's going to look like that, month **2** is going to look like that. You go all the way to month **60**, which is the last month in the five years, and it's going to look like that. So, that's month **60**. This is over the course of five years. The idea is fairly similar. You're going to pay some part of this is going to be interest, and the remainder is going to actually be used to pay down the loan. Each month, you're going to pay down a little bit more of the loan, and you're going to have to pay a little less in interest. When we get a little bit bigger, you're going to have to pay a little less in interest because you have less remaining on your loan. By month **60**, you still haven't paid your loan off, so maybe the interest is right over here. Maybe the interest is right over there. It will probably be higher than that; I don't want to be too exact, but maybe your interest is going to be right over here, and then this is what you're paying down from the loan for a hybrid adjustable rate mortgage. After that five-year period, the bank can now change the interest rate, and the interest rate is going to be dependent on some kind of underlying thing that everyone is paying attention to. If that underlying thing increases in interest—so in this **5/1 ARM**, it starts off at a **3%** interest. If, because of this thing that we're paying attention to—and I'll talk more about that in a second—interest rates all of a sudden go up, then all of a sudden your payment could increase. Your payment could increase because the general idea behind a **5/1 ARM** is that you are still going to pay it off in **30 years**. So, they typically have a **30-year term**. If you just stick with this loan, you never try to borrow other money to replace this loan, which is called a **refinance**. If you just stick with this loan, it will take you **30 years** to pay it off. But after the first five years, the amount of interest you pay might actually change, and so your payment might actually change. If the interest rate goes up, all of a sudden, you might have to pay a lot more interest all of a sudden in month **61** or in year **6**. In year **6**, let me do that in that same blue color. For year **6**, since this is a **5/1 ARM**, they can't change the interest rate again until year **7**. So, you'll pay this constant amount until year **7**, and then they can change the rate again. There usually are some caps on how much they can change the rate each year or how much they can change the rate in total, but it is a little bit riskier because you really don't know what your payment might be in year **6** or year **7**, especially if interest rates go up a lot. Now, you might be asking what determines what that new interest rate is after the five years. They usually pick some type of index. The most typical are especially the **United States Treasury securities**. So, they look at the **10-year Treasury interest rate** that essentially the government has to pay when it borrows money, and they'll usually take some premium over this. So, if the **10-year Treasury** is at **2%**, the bank might put in your loan documents that after the initial five-year fixed period, you will pay a **10-year Treasury rate** plus maybe you'll pay that plus **1%**. So, you start off paying the **3%** that's fixed. Even if the Treasury does all sorts of crazy things—even if it goes up to **5%**, you're just going to keep paying the **3%** for the first five years. But then in the sixth year, let's say that in year **6**, the **Treasury** rate now has bumped up to **4%**. Then, by contract, by what's in your loan document, you're going to have to pay that plus **1%**, so now your mortgage is going to reset to have a **5%** rate. You might get lucky, though. Maybe the **Treasury** rate goes down; maybe it goes to **1%**, and then your mortgage rate would actually be **1% + 1%**, so it could actually go down to **2%**. But the general idea is that that's a little bit riskier because you really don't know how predictable that payment is going to be. If you look at most times, if you look at quoted interest rates, you'll see that the **30-year fixed rate** is higher than the **15-year fixed rate**, which is higher than the **adjustable rate**. That's because the bank—there's a couple of different forms of risk—but the bank is taking the least amount of risk on the adjustable rate mortgage and taking the most risks on the **30-year fixed**. The biggest risk here is the risk that you don't pay it off, but that's why they like to see a down payment because they can get the house back, and hopefully, the house doesn't devalue by more than your down payment. But even more than that, there's an interest rate risk because what happens if the bank lends you money—a big chunk of money—at **5%**, and that interest rates go up to **6%**, **7%**? What if they go up to **10%**? What if the bank's borrowing cost—the amount of money the bank has to pay people to borrow money—goes up to **10%**? Then they'll be taking a loss on your loan. So, they're fixing it for so long. That's why they want to make up for some of that risk by charging you higher interest. A **15-year loan** has a little bit less risk, so they'll have a little bit lower interest. A **5/1 ARM** has even lower risk; they're only fixed for five years, and then after that, they can float with the prevailing interest rate on an annual basis. Hopefully, that gives you a little bit of a primer on mortgage interest rates, but I want to really make sure that you don't view just this video as all you need to take out a loan. It's super important to read the fine details on what's happening with that loan, especially if you're buying something more—if you're taking out a more exotic loan like an adjustable rate mortgage or an interest-only loan or an option ARM or any of those more exotic things.

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