In talking about interest rates, there are many different variations depending on the kind of debt and your needs. It will all make sense once we explore each one individually.
Fixed Interest Rates
A loan with a fixed interest rate is a rate that is stable throughout the term of a loan. Common loans that have fixed rates are mortgages, student loans, and personal loans. In taking out a loan for your home, you have a choice of a mortgage with an ARM or Fixed rate. With fixed rates, the Annual Percentage Rate (APR) will not change for the entire term loan. For example, A 30-year mortgage loan at an interest rate of 4%, where the interest rate stays the same for the entire 30 years. Typical fixed rate loans are 10, 15, 20, and 30 years.
Variable Interest Rates
Variable interest rates vary over the term of the loan. An ARM (adjustable rate mortgage) is where you have a variable interest rate that rises and falls with the market. Due to the volatility, the loans typically start at a lower APR than fixed rates to attract more borrowers. They are usually based on a specified index, such as the prime rate or LIBOR. https://www.eaglemortgagecompany.com/loan-programs/arm-commonly-used-indexes/ The index is then added to the lender’s spread or margin to get the final rate. Common examples of variable rate interest include mortgage and credit cards. Within the family of variable rates, there are many options.
Adjustable Rate Mortgage
In an ARM you get offered a fixed rate for a period of time and then the loan is variable during another period which it can adjust upward or downward depending on the market. The LIBOR (London Interbank Offered Rate) is a popular benchmark that is used for this purpose. Common examples of ARM loans are 5/6, 7/6, or 10/6. The first number indicates the fixed portion (in years) at the stated rate. The second number indicates how often it is reevaluated, in months. A 5/6 would have a fixed rate for 5 years and then adjust (per the market) every 6 months. Making it more palatable to the borrower.
Caps
ARM loans do have caps. And that means how much the interest rate can change over the term of the loan or per adjustment period. So, an ARM with caps of 5/2/5 means that after the initial fixed period, the maximum that the interest rate can adjust is 5% up or down—that’s a heckuva jump, isn’t it? The 2% is for other adjustment periods throughout the loan and the 5% means the lifetime cap of 5% increase/decrease. If you have an 5/6 ARM with caps of 5/2/5… that means that you have a fixed rate for 5 years (the 5 of 5/6) and your rate will adjust every 6 months after that (6 of the 5/6). After 5 years, your rate will not adjust more than 5% up or down (5 of 5/2/5 cap). Every 6 months after, your rate is capped at a 2% (2 in 5/2/5) increase or decrease from the previous adjustment period. If inflation is increasing tremendously, you have a lifetime cap of 5% (last 5 in 5/2/5).
At the end of the fixed rate time period, you generally are allowed to refinance and change to a fixed rate at that point. However, there are no guarantees that you will be able to qualify with the current mortgage rules and programs. A lot can change in five years. Many people who own investment property for flipping or short-term ownership, choose ARMs since they will be selling or refinancing within the initial low-rate period.
With the downturn in the market in 08 and 09, most of the loans that defaulted were ARMs. What happened was that many borrowers qualified at the lower ARM interest rate hoping to get raises over the years and have the value of the home increase. Unfortunately, the market hit a bubble so home values plummeted dramatically. In addition to that and the rise in inflation and unemployment, many did not have the extra money to be able to pay for the increases in their mortgage payment (due to ARM adjustments) which caused an epidemic of foreclosures with job losses all throughout the housing industry. Fixed interest rate holders were sitting in a better position as it was not tied to the plummeting market. Only those that decided to sell during that time period felt the hit.
Compound Interest Can Make You Rich or Poor
Interest is present when you’re saving money, but also when you borrow money. So, it can be a blessing or a curse.
Savings
When you invest money, you earn interest. With each accumulation period, you then earn interest on your principal and interest. All you need is time. Let’s take a $100 investment. If you put $100 in an investment account that earns a 5% interest rate (not that high), contribute $5 a month thereafter, you’ll have over $14,000 after 50 years. Even though 50 years is a long time, it illustrates the growth using compound interest. Doing the same thing for 20 years will yield over $2,000. That’s a big reason why you should open an IRA (individual retirement account) as soon as you’re working. You can do this, even if you’re working only part time.
Borrowing
Interest can be a blessing when you’re earning it, but a curse when you’re borrowing. Drawing your attention to the unsubsidized college loans that so many people deal with. The current maximum amount that students are offered are $5,500 as a freshman, $6,500 as a sophomore, and $7,500 as a junior/senior for a total of $27,000 over four years. Even though the loans are not required to be paid back until six months after graduation, the interest begins accruing immediately upon procurement. What does that mean? That means if you borrow $5,500 for the first year, by the end of the year, you owe more than you borrowed and it will continue for four more years until the payments begin. What’s even worse is that it is compounded DAILY. So, if you’re borrowing $2,271 (1/2 of $5,500 minus fees) and you have an interest rate of 2.75% (current federal loan APR), you pay .0075%/day. So, on day one, you pay 17.03 cents in interest. However, on day two, your interest is calculated on the new amount of $2,271.17 and on day three, you are charged 17.12 cents bringing your balance to $2,271.34. It may seem that it’s not growing very much but think about that compounding over 4 1/2 years. It’s all working against you. If you can keep up with paying at least the interest (perhaps monthly), then you may actually come out owing the amount you borrowed versus a potentially much higher amount. *Interest has been deferred since September 2020 due to Covid and is set to resume in September 2023.
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