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## Finance and capital markets

### Course: Finance and capital markets>Unit 2

Lesson 3: Mortgages

# Mortgage interest rates

In this video we explore the different types of interest rates you might encounter. Topics include the difference between fixed rate mortgages, adjustable rate mortgages, and hybrids such as 5/1 loans. Created by Sal Khan.

## Want to join the conversation?

• In the 5/1 ARM does the "1" refer to the number of times per year after the fifth year the rate can change or to every how many years after the fifth year the rate can change? For example, would a 5/2 ARM mean after 5 years the rate can change up to twice per year? Or would it mean the rate can change up to once every 2 years?
• A 5/2 ARM means that after 5 years the rate can change every 2 years thereafter.
• When a bank forecloses on your house do they gain all the equity or do you get the remaining equity after the bank has taken the amount for their loan+interest owed?
• If a bank wanted to foreclose on you, but the house was worth more than what you owed, you could just sell the house, pay the bank back and keep what's left.
• On each monthly mortgage payment, why is a certain percentage interest and a certain percentage principal? Money is money (whether it is being paid for the loan/mortgage, or interest), right? Does the interest go to a different bank than the amount being paid for the mortgage?

Also, why does the ratio of interest to principal change for each monthly payment (over time the amount of interest being paid lowers and the amount of principal being paid rises)?

If you're paying \$2,000 a month, why isn't it 50% interest, 50% principal until the end of 30 years? I'm referencing in the video.
• I had this same question, and Sal has done other great videos to explain it. You're right, money is money. It's not like paying interest is any different from paying principal. But when we say we paid interest, we just mean we paid the amount of money increased to our debt by interest. Once that's paid for, we're back where we began, with the principal. Now, every dollar we pay will mean the interest for next month will be smaller, because the interest rate will be the same. You take the same percentage from a smaller amount. And if your mortgage is the same, then you're giving the same amount of money for a smaller interest, which means you have more left over to chip at the principal. Hence, the percentages of your question. So to answer the example you gave, if you pay \$2000 a month, as long as the first interest is smaller, every other interest will decrease with each month. That way you may start by paying \$1000 dollars in interest, 50% like you said. But then the other \$1000 will decrease your principal, so the interest for the following month MUST be smaller than \$1000, therefore accounting for a smaller percentage of what your mortgage pays!
• Does the 5/1 ARM adjust every 5 years? Will it change in the 6th year, 11th year, 16th year and so on? After the interest rate is adjusted in year 6, will the same rate rate continue till year 11?
• In a fixed rate mortgage, is it advantageous to pay more than your fixed monthly payment each month? Could you pay down your debt faster, and therefore save money that you would have had to pay on interest in the last months? Or is it disadvantageous to do this, because of the value of having that extra money in your pocket to do other things during the life of your loan?
• I think you need to compare the interest rate on your mortgage to another investment opportunity. If your mortgage rate is 4% and you reasonably think you can get a better rate of return on some type of investment you might want to consider doing that rather than paying down your mortgage.
(1 vote)
• Why does an increase in interest rates cause inflationary pressure in the Housing markets and for wages?
• Who says it does? Unless the reason the interest rates went up is because inflation went up, an increase in interest rates would tend to deflate the housing market, not inflate it.
• At , what does Sal mean when he says "when the bank will be taking a loss on your loan" ?
(1 vote)
• It's a comparative loss of earning power. If the bank could earn, say, 7% on new mortgages, but you're only paying the 5% mortgage interest (and will keep paying that same amount for decades) then the bank loses that higher income potential. They are "locked" into your low-rate loan for up to 30 years when they might make more interest on new loans at higher rates. Thus, long-term loans typically have higher rates to reflect that higher risk.

To look at it another way, if rates fall, then borrowers often refinance to take advantage of the lower rate and the lower payment. But if rates rise, the bank can't refinance. They can't force the borrower to borrow again at a higher rate just so that the bank will earn more interest. So the bank tries to get the highest rate it can at the beginning, as high as the market will bear.