Impact of Interest Rates

When choosing between an adjustable-rate mortgage and a fixed-rate mortgage, many people don't realize that they are making a choice between a mortgage on which the interest rate is determined by either short-term or long-term interest rates. "What's a short-term versus a long-term interest rate?" you say. When a mortgage lender quotes an interest rate for a particular type of loan, he should specify (in terms of how many years until the loan is completely paid off) the length of the loan.

Most of the time, borrowers must pay a higher interest rate to borrow money for a longer period of time. Conversely, borrowers generally pay a lower rate of interest for shorter-term loans. So?

Well, the interest rates that are used to determine most adjustable-rate mortgages are short-term interest rates; whereas fixed-rate mortgage interest rates are dictated by long-term interest rates. During most time periods, longer-term interest rates are higher than shorter-term rates because of the greater risk the lender accepts in committing to a longer-term rate.

It stands to reason, therefore, that when little difference exists in the market level of short-term and long-term interest rates, the rates of fixed-rate mortgages shouldn't be all that different from the rates of adjustable-rate mortgages. Thus, adjustables appear less attractive, and fixed-rate mortgages appear more alluring.

On the other hand, when short-term interest rates are significantly lower than long-term interest rates, adjustable-rate mortgages should be available at rates a good deal lower than the rates for fixed-rate loans. All things being equal, adjustables appear more attractive during such time periods and save you more money during the early years of your loan.