Finance and capital markets
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.
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- 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?(11 votes)
- 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?(4 votes)
- 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.(10 votes)
- 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 referencing4:20in the video.(5 votes)
- 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!(2 votes)
- 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?(3 votes)
- 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?(3 votes)
- 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?(2 votes)
- 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.(3 votes)
- At13:28, 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.(3 votes)
- Why are the first mortgage payments mostly interest? Isn't a mortgage payment supposed to be to pay down the mortgage?(2 votes)
- If you change banks while still paying off your mortgage, does the money go to the bank that you loaned from, or the bank that you did not?(1 vote)
- What do you mean "change banks"? You can't change the bank you owe the mortgage to. You owe them money and you have to pay them.(3 votes)
- What would happen if the person who made the loan died before his 30 years were over? Would it get passed on to his family? or would the bank just take the house? or what........(1 vote)
Narrator: When most people buy a house they need to borrow money for some part of the purchase price of the house. Let's say that we have a house right over here and the purchase price is $200,000, and I want to buy this house, and I've saved up $40,000. I have saved up $40,000, so this is my savings, so I will use this as a down payment, but I still need to borrow the rest of the money in order to get to $200,000. I'm going to have to get the balance, the $160,000 as a loan. The type of loan that people that people will get, or that they usually get to buy a house is called a mortgage. Mortgage. A mortgage is really just a loan where if you don't pay the loan off, the person that you borrowed the money from gets the house. Another way to think about it is it's a loan that's secured by the house until you pay off the loan. When you pay off the loan it is your house to keep, but at any point if you don't pay it, the bank could come and take the house, and that is called a foreclosure. Now, what I want to focus on in this video is the types of mortgage loans you will typically see, and give you at least the beginning of an understanding of how to understand what these different types of loans mean. In all of these scenarios, let's just assume that I'm in the market to borrow $160,000 for this house I'm about to buy. If you look at any financial website or any of the major search-web portals, they'll give you quotes for mortgage rates. You'll see something like this. I made these numbers really simple. Normally, you'll have some decimals here; 5.25%, 4.18%. I made these numbers a little bit simpler just to make them simpler. These are the typical types of mortgage you will see, but if you contact mortgage broker they will have many, many more types, more exotic types; but these are the most common and this is what we'll cover in this video. Hopefully they'll give you a sense of what the other types of mortgage is like. A 30 year fixed mortgage means that your payment and your interest rate are fixed over 30 years, and over the course of those 30 years you will pay off your loan. In this situation, this is a 30 ... Let me write it over here, let's think about a 30 year fixed. 30 year fixed mortgage. What will happen is you will have a fixed mortgage payment every month, and I'll draw a little bar graph to show the size of your payment. You'll see why I'm doing that in a second. Let me just draw a little bit of a graph here. Each of these blocks represent your monthly payment for that month; and I'm just going to make up the number, let's say it is $2,000. I actually haven't figured out the math of what is the exact payment for a 30 year fixed with a 5% interest rate for $160,000; but, let's just say, for the sake of simplicity, it's $2,000 a month. This height right over here, let me make it like this. This is $2,000 a month. $2,000. This is month 1, then you will pay $2,000 in month 2. So on and so forth, all the way. If you have 30 years times 12 months, you're going to get all the way to month 360; and that is going to be your last payment. Month 360 is the last payment in year 30, and you would have paid off your loan. The interesting thing here is in the first month, since you've borrowed so much from the bank, you've borrowed $160,000, the interest that you have to pay on it is going to be pretty large. Most of the initial payments are going to be interest. I'm going to do the interest in this magenta color. In that first payment. Oh, that's not magenta. This is magenta. In that first payment it's going to be mostly interest. You're going to pay a little bit off of the actual loan; so that right there is your principle payment. Let's say, after that first month, the principle part of that $2,000 is, and I'm just making up numbers for the sake of simplicity, let's say that is $200, and the interest portion is $1,800. I'm not actually working it through with these assumptions. You don't even have to assume that's a $160,000 loan, but the general idea here is after this first month you would have paid $200 off of your loan. If it was $160,000 loan, after that fist month, you don't owe $160,000 minus 2,000, because 1,800 of that was interest. You now owe $160,000 minus $200, so you now owe $159,800. In the next period your interest is going to be a little bit lower. It's going to be just a little bit lower, and your principle, since you're paying the same fixed payment of $2,000 every month, is going to be a little bit higher. Maybe it's going to be, in the next month, something slightly higher; I don't know, $202. You keep going like that and the math works out; they figure out the payment so that by that last payment you're paying very little interest, you're paying very little interest, and most of that last payment is principle. It's actually being used for the loan, and then after that last payment, the loan is paid off. This will happen over 30 years; this is a 30 year term. A 15 year fixed is the same exact idea, except instead of it taking 30 years to pay off the loan, you're going to do it over 15 years. Instead of it being 360 months, in the 15 year case, it is going to be 180 months; and because of that, your payment for the same loan amount is going to be higher every month because you're paying it off quicker. You're paying it off in fewer months. Instead of $2,000 a month, maybe it is something like $2,800 a month for the 15 year case. You're paying it off quicker. The 5/1 ARM case, and you'll see, and there are many types of ARMs, and I'm going to explain to you in a second what an ARM is, but the 5/1 is the most typical. I'll explain what that means in a second. ARM means 'Adjustable Rate Mortgage.' Adjdustable Rate Mortgage As you see, in these situations we had the word 'fixed,' and they were called fixed because the interest rate was fixed; whatever your remaining loan balance was you paid the same fixed amount of interest for the next period. For this 30 year fixed, we are being quoted a 5% fixed rate over the next 30 years; will not change. For the 15 year, we're quoted a 4% fixed rate. For the ARM, the rate can change. When someone tells you about a 5/1 ARM, they're actually talking about something called a hybrid ARM; but, the general idea behind an adjustable rate mortgage is the amount of interest you pay on your remaining balance will change. It will change according to some index. The most typical types of adjustable rate mortgages are things like this hybrid ARM; so this is a hybrid. A hybrid, it's viewed as a mixture of 2 things, or a combination of 2 things. What a hybrid adjustable rate mortgage is it has fixed rate for some period of time. In this case, it's a fixed rate for 5 years, then the interest rate can change once a year after that, or every 1 years after that. That's what this right over here is telling you. In the case of an adjustable rate mortgage your payment might look something like this, and I'll just make up numbers for simplicity just to give you the flavor of what it might look like. In the case of a 5/1, your first 5 years are fixed. Your first 5 years. Month 1 is going to look like that. Month 2 is going to look like that. You go all the way to month 60, which is the last month in the 5 years and it's going to look like that. That's 1, that's month 2, that is month 60. This is the course of 5 years. This is over the course of 5 years. Over the course of 5 years, the idea is fairly similar. You're going to pay, some part of this is going to be interest, and the remainder is going to actually be used to pay down the loan. Each month you're going to pay down a little bit more of the loan, and you're going to have to pay a little less in interest. Make that a little bit bigger. You're going to have to pay a little bit less interest, because you have less remaining on your loan, but by year 5, or month 60, you still haven't paid your loan off. Maybe the interest is right over there, and actually it'll probably be higher than that. I don't want to be too exact, but maybe your interest is going to be right over here; and this is what you're paying down from the loan. For a hybrid adjustable rate mortgage, after that 5 year period, the bank can now change the interest rate. The interest rate is going to be dependent on some kind of underlying thing that everyone is paying attention to. That underlying thing increases in interest. In this 5/1 ARM, it starts off at a 3% interest. If, because of the thing that we're paying attention to, and I'll talk more about that in a second, interest rates all of a sudden go up. Let's say they go up a lot, then all of a sudden your payment could increase. Your payment could increase because the general idea behind a 5/1 ARM is that you are still going to pay it off in 30 years. They typically, I should say, have a 30 year term. If you just stick with this loan, you never try to borrow other money to replace this loan, which is called a refinance, if you just stick with this loan it will take you 30 years to pay it off, but after the first 5 years the amount of interest you pay might actually change, so your payment might actually change. If the interest rate goes up, all of a sudden you might have to pay a lot more interest all of a sudden in month 61, or in year 6. Let me do that in, I can do that part in that same blue color. For year 6, since this is a 5/1 ARM, they can't change the interest rate again until year 7, so you'll pay this constant amount until year 7. Then, they can change the rate again. There usually are some caps on how much they can change the rate each year, or how much they can change the rate in total; but it is a little bit riskier because you really don't know what your payment might be in year 6, or year 7, especially if interest rates go up a lot. Now, you might be asking what determines what that new interest rate is in after the 5 years. They usually pick some type of index. The most typical are, especially in the United States, treasury securities; so, they'll look at the 10 year interest rate that essentially the government has to pay when it borrows money, and they'll usually take some premium over this. If the 10 year treasury is at 2%, the bank might put in your loan documents that after the initial 5 year fixed period, you will pay 10 year treasury rate plus, maybe you'll pay that plus 1%. You start off paying the 3%, that's fixed even if the treasury does all sorts of crazy things, even if it goes up to 5%, you're just going to keep paying the 3% for the first 5 years, but then in that 6th year, let's say that, let me write it over here, let's say that in year 6 the treasury security rate now has bumped up to 4%, then by contract, by what's in your loan document, you're going to have to pay that plus 1%. Now, your mortgage is going to reset to have a 5% rate, have a higher rate. You might get lucky, though. Maybe the treasury rate goes down, maybe it goes to 1%, and then your mortgage rate would actually be 1% plus 1%, so it could actually go down to 2%. But the general idea is that's a little riskier, because you really don't know how predictable that payment's going to be. Most times, if you look at quoted interest rates, you'll see that the 30 year fixed rate is higher than the 15 year fixed rate, which is higher than the adjustable rate. That's because the bank, there's a couple of different forms of risk, but the bank is taking the least amount of risk on the adjustable rate mortgage, and taking the most risk on the 30 year fixed. The biggest risk here, there's the risk that you don't pay it off; but that's why they like to see a down payment, because they can get the house back and hopefully the house doesn't devalue by more than your down payment. But, even more than that, there's an interest rate risk. Because what happens if the bank lends you money, lends you a big chunk of money at 5%, and that interest rates go up to 6%, 7%, what if they go up to 10%? What if the bank's borrowing cost, the amount of money the bank has to pay people to borrow money, goes up to 10%? Then it will be taking a loss on your loan, and they're fixing it for so long, that's why they want to make up for some of that risk by charging you higher interest. A 15 year loan? A little bit less risk, so they'll have a little bit lower interest. A 5/1 ARM? Even lower risk. They're only fixed for 5 years, and then after that this will float with the prevailing interest rate on an annual basis. Hopefully that gives you a little bit of a primer of mortgage interest rates, but I want to really make sure that you don't, just this video isn't all you need to take out a loan. It's super important to read the fine details on what's happening with that loan, especially if you're buying something more, if you're taking out a more exotic loan like an adjustable rate mortgage, or an interest-only loan, or an option ARM, or any of those more exotic things.