Here’s an interesting question: “What mortgage has the best interest rate?”
Before we dive in, “best” questions are always a bit difficult to answer universally because what’s best to one person could be the worst for another. Or at least not quite the best.
But we can still examine what makes one mortgage rate on a certain product better than another, in certain situations.
In a recent post, I touched on the different mortgage terms available, such as a 30-year, 15-year, and so on.
That too was a “best” article, where I attempted to explain which mortgage term would be best in a particular situation.
Related to that is the associated mortgage interest rate that comes with a given term.
Longer Term = Higher Mortgage Rate
- The longer the mortgage rate is fixed
- The higher the interest rate will be all else being equal
- To compensate the lender for taking more risk
- On interest rates over a longer period of time
Now I’m going to assume that by best you mean lowest, so we’ll focus on that definition, even though it might not be in your best interest. A lot of puns just happened by the way.
Simply put, a longer mortgage term generally translates to a higher mortgage rate.
So a 10-year fixed-rate mortgage will be much cheaper than a 40-year fixed loan for two borrowers with similar credit profiles and lending needs.
Additionally, an adjustable-rate mortgage will price significantly lower than a fixed-rate loan, as you’re guaranteed a steady rate for the full term on the latter.
This all has to do with risk – a mortgage lender is essentially giving you an upfront discount on an ARM in exchange for uncertainty down the road.
With the fixed-rate loan, nothing changes, so you’re paying full price, if not a premium for the peace of mind.
If the interest rate is fixed, the shorter term loan will be cheaper because the lender doesn’t have to worry about where rates will be in 20 years.
For example, they can offer you a lower mortgage rate on a 10-year term versus a 30-year term because the loan will be paid off in a decade as opposed to three.
After all, if rates rise and happen to triple in 10 years, they won’t be thrilled about your low rate that’s fixed for another 20 years.
That’s all pretty straightforward, but knowing which to choose could be a bit more daunting, and may require dusting off a mortgage calculator.
Mortgage Interest Rates from Cheapest to Most Expensive
- 1-month ARM (cheapest)
- 6-month ARM
- 1-year ARM
- 3/1 ARM
- 5/1 ARM
- 10-year fixed
- 7/1 ARM
- 15-year fixed
- 10/1 ARM
- 30-year fixed
- 40-year fixed (most expensive)
This can definitely vary from bank to bank, but it’s a rough order of how mortgage rates might be priced from lowest to highest, at least in my view.
Most lenders don’t even offer all these products, but you can get an idea of what’s cheapest and most expensive based on its term and/or how long it’s fixed.
Currently, the popular 30-year fixed is pricing at 4.06%, while the 15-year fixed is going for 3.51%, per the latest weekly Freddie Mac data.
The hybrid 5/1 ARM, which is fixed for the first five years and adjustable for the remaining 25, is averaging a slightly lower 3.68%.
As you can see, the 30-year fixed is the most expensive. In fact, it’s nearly half a percentage point higher than the average rate on a 5/1 ARM.
This spread can and will vary over time, and at the moment isn’t very wide, meaning the ARM discount isn’t great.
At other times, it might be a difference of one percent or more, making the ARM a lot more compelling.
Anyway, on a $200,000 loan amount, that would be a difference of roughly $44 in monthly mortgage payment and about $2,640 over five years.
A 3/1 ARM or one-year ARM would be even cheaper, though probably just slightly. And for a loan that adjusts every three years or annually, it’s a big risk in an environment where interest rates are likely at or near the bottom.
As mentioned, the low initial rate on the 5/1 ARM is only guaranteed for five years, and then it becomes annually adjustable for the remainder of the term. That’s a lot of years of uncertainty. In fact, it’s 25 years of risk.
The 30-year fixed is, well, fixed. So it’s not going higher or lower at any time during the loan term.
The ARM has the potential to fall, but that’s probably unlikely given where rates are historically. And lenders often impose interest rate floors that limit any potential interest rate improvement.
So What’s the Best Interest Rate Then?
- The best mortgage rate is the one that saves you the most money
- Once you factor in the monthly payment, closing costs, and interest expense
- Along with what your money could be doing elsewhere
- And what your plans are with the underlying property (how long you intend to keep it, etc.)
The best interest rate? Well, that depends on a number of factors unique to you and only you.
Do you plan to stay in the property long-term, or is it a starter home you figure you’ll unload in a few years once it’s outgrown?
And is there a better place for your money, such as the stock market or another high-yielding investment?
If you plan to sell your home in the medium- or near-term, you could go with an ARM and use those monthly savings for a down payment on a subsequent home purchase.
Just be sure you have enough money to make larger monthly payments if and when your ARM adjusts higher if you don’t actually sell or refinance your mortgage before then.
Five years of interest rate stability not enough? Look into 7/1 and 10/1 ARMs, which don’t adjust until after year seven and 10, respectively.
That’s a pretty long time, and the discount relative to a 30-year fixed could be well worth it. Just expect a smaller one relative to shorter-term ARMs.
If you’ve got plenty of money and actually want to pay off your mortgage early, a 15-year fixed will be the best deal, as you’ll get the lowest, fixed rate available.
The shorter term also means less interest will be paid to the lender. The downside is the higher monthly payment, something not every homeowner can afford.
As a rule of thumb, when interest rates are low, it makes sense to lock in a fixed rate, especially if the ARM discount isn’t a lot.
Conversely, if interest rates are high, taking the initial discount with an ARM may make sense.
In the event rates have fallen when it comes time to refinance (after the initial fixed period comes to an end), you could make out really well.
And even if rates fall shortly after you get your mortgage, you can always refinance to another ARM, thereby extending your fixed period a bit longer.
Or simply go for a fixed-rate mortgage if rates get really good.
The other side of the coin is that rates could keep climbing, putting you in a tough spot if your ARM adjusts higher and interest rates aren’t favorable at the time of refinancing.
Ultimately, you’re always taking a risk with an ARM, though you could also be leaving money on the table with the fixed-rate loan, especially if you don’t keep it anywhere close to term.
Either way, watch those closing costs and be wary of resetting the clock on your mortgage if your ultimate goal is to pay it off in full.
In the end, it may all just come down to what you’re comfortable with.
For many, the stress of an ARM simply isn’t worth any potential discount, so perhaps a fixed mortgage is “best.”
Read more: Which mortgage is right for me?