NEW YORK (MainStreet) — When it comes to mortgages, everyone knows a low rate is better than a high one, because the interest charges are smaller. But there's another benefit that's often overlooked: A lower rate helps you build home equity faster.
It's another factor to consider in deciding whether to buy or refinance now or wait until later, when interest rates might be higher. If you're thinking of moving, for instance, it might be more convenient to hold off until next summer to move during the school break. But since rates could rise, moving sooner would allow you lock in the dual benefits of lower rates — less interest and faster-growing equity.
Rates rose fairly substantially from spring through summer, with the typical 30-year fixed-rate loan going from about 3.5% in May to 4.75% in early September. The increase anticipated an economic recovery that would cause the Federal Reserve to eventually pull back on its policy of keeping rates low. But the Fed has postponed that move, and the rate has drifted down to about 4.5%
That's awfully good by historical standards, as borrowers have often paid 7% or more. It seems highly unlikely we'll be back at 7% anytime soon, unless a Washington stalemate on budget talks leads to a debt default early next year.
But for the sake of argument, let's consider the difference between a $100,000 loan at 7% versus 4.5%.
The 7% loan would charge $665 per month, and you'd pay $139,500 in interest over 30 years. At 4.5%, the payment would be $507 and total interest $82,405. That's clearly a good reason to borrow when rates are low.
But what if you kept the loan for just 10 years, about average given the pace at which people move or refinance? The 7% loan would charge $65,665 in interest over that period, versus $40,891 for the 4.5% mortgage, a huge difference.
But wait, there's more: After 10 years you'd still owe $85,811 on the 7% loan, but just $80,089 on the 4.5% loan. If you sold your home, you'd pocket about $5,000 more if you'd had the loan with the lower rate.
Why is this? It has to do with the calculations for creating an amortization schedule, which determines how each month's payment is divided between principal and interest. As each payment reduces the outstanding loan balance, the interest charge gets a little smaller, as if a new loan were being issued for a slightly smaller amount. Since the monthly payment stays the same, the reduction of the interest charge allows more of the payment to go to principal, causing an even greater reduction in the interest charge the following month.
If you pay a lower interest rate, this process moves faster, because a bigger portion of the payment goes to principal right from the start. With the 7% loan, the first payment allocates $82 to principal, compared with $132 with the 4.5% loan. Use this calculator to see how balances fall with any given mortgage.
Paying principal off faster means building equity faster, since equity is the difference between the home's value and the outstanding debt. It's what you'd pocket after using the sales proceeds to pay off the loan balance.
If you keep the mortgage for the full 30 years, this is no longer a factor, since both loans would reduce the balance to zero with the final payment. Of course, you'd still benefit from the lower-rate deal because overall interest charges would be smaller.
But if you expect to own the home for just five or 10 years, the lower-rate loan will provide that extra benefit of paying down principal faster. It's just another reason not to procrastinate on a home purchase or refinance. Most experts agree that the odds of rates going up over the next year are much stronger than the odds they'll go down.
--Written by Jeff Brown for MainStreet