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Two-thirds of U.S. households own their own homes (as
opposed to renting), and most homeowners pay a mortgage.
Thus, the level of mortgage rates determines how much
all these homeowners have left to spend on other things.
How much people can spend on other things, in turn, affects
the overall economy.
Interest rates on home mortgages are important because
mortgage interest is a major item in many people’s budgets.
Even small changes in mortgage interest rates can have
a large impact on how affordable it is to own a home.
That’s important, because homeownership is the major
way many families build up wealth.
The interest payments over the life of a mortgage often
add up to more than the amount of the mortgage loan.
For example, the interest payments on a 30-year, $100,000
mortgage at a 7% interest rate will add up to about
$140,000 over the 30 years.
People who have mortgages may deduct the interest they
pay from their income in calculating how much income
tax they have to pay. That’s a significant benefit of
owning a home.
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The interest rate for a fixed-rate mortgage remains the
same for the life of a mortgage, and the monthly payment
also stays the same for the life of the mortgage.
For example, a 30-year, $100,000 mortgage at an interest
rate of 7% requires a monthly payment of $665.30. Every
month for 360 months, the payment of principal plus
interest equals $665.30.
The vast majority of the monthly payment in the early
years of the mortgage is for interest, and only a small
amount reduces the principal, the amount of the original
loan still owed. The opposite is true in the latter
years of the mortgage.
Therefore, most of the monthly payment in the early
years of the mortgage is income-tax-deductible, but
very little of the payment in the later years is deductible.
Usually, however, homeowners will find the payments
more affordable in the latter years, because incomes
generally rise, and inflation reduces the "real"
burden of the fixed payment.
| For a calculation of the monthly payment on a
mortgage of any size, duration, and interest rate
you choose, click on www.chicagofed.org,
and then on "Consumer Information," "Interest
Calculators," and "Mortgage Calculator." |
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Refinancing — taking out a new mortgage and paying off
your old one — may be advisable if mortgage rates are
lower than when you took out your mortgage.
Refinancing involves some costs, though — legal fees,
points on the new mortgage, and others — so refinancing
doesn’t pay if rates have fallen only slightly.
Experts usually advise against refinancing unless the
new rate is at least two percentage points lower than
the rate you’re currently paying.
How long you plan to stay in the house is another factor
to consider. If you don’t plan to stay in the house
very long, you may not enjoy the benefits of the lower
rate long enough to make the costs of refinancing worthwhile.
People sometimes refinance their mortgages for reasons
other than to save on interest costs. They may want
to take out a larger mortgage, for example, in order
to use the extra cash for a major purchase.
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An adjustable-rate mortgage has an interest rate that
moves up and down based on changes in some other rate,
called the "index rate." A common index rate
is the rate on a specified U.S. Treasury security.
An ARM typically has a lower initial interest rate
than a fixed-rate mortgage, but the ARM rate is adjusted
periodically (perhaps every year), based on changes
in the index rate.
Many ARMs place a limit on how much the interest rate
can rise in a single adjustment or over the life of
the mortgage. Similarly, some ARMs limit how much the
monthly payment can increase as a result of a periodic
adjustment. That limits the risk that the borrower will
be unable to make the payments, but a potential problem
related to the payment cap is that of "negative
amortization," or an increasing mortgage balance.
That can happen if the payment cap does not allow the
increase in the payment to cover the increase in the
interest due each month.
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