Fixed vs. Adjustable Rates by Carey PottApples vs. oranges. Boxers vs. briefs. Dave Letterman vs. Jay Leno. These debates may rage on for decades, and we can add another one to the list: fixed vs. adjustable. We're speaking, of course, of fixed rate and adjustable rate mortgages.
Let's start the discussion by talking about risk. If I had to pick one word that explained the mortgage industry, it would be risk. If you can understand the concept of risk and how it relates to mortgages, you're way ahead of the game. In a nutshell, riskier loans mean higher interest rates; you compensate the person lending you money by paying them a higher interest rate. If you have low FICO scores, this is a higher risk to the investor since you don't have a good history of paying your bills on time, so you're going to have to pay a higher rate. If you can't verify enough income to qualify for the loan, this is a higher risk and you're going to have to pay a higher interest rate.
As it relates to this discussion, the longer you ask the lender to guarantee your interest rate, the higher risk for them since they're guaranteeing the rate you get but they don't know how much their funds are going to cost them going forward. This isn't an easy concept to wrap your mind around, so don't feel bad if you don't get it yet. Lenders work on a concept called arbitrage, which is a fancy way of saying they borrow money at a certain rate and then lend it out to you. However, lenders don't get money at 30-year fixed rates, so when they borrow money they have to try to gauge what it's going to cost them over the time they lend it to you. If you're following me so far, you can understand why they would charge a higher rate to guarantee you a certain rate for 30 years as opposed to 3 or 5 years. Now, on to our discussion...
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