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Why Shorter Terms Pay Lower Interest Rates And Other Interesting Facts

Where is the logic in the way that lenders choose interest rates? Why are fifteen-year home loans cheaper than thirty-year mortgages? To understand how banks and finance companies set prices you have to look at it from their perspective, the point of view of the people who are lending the money. They are in it to earn a living from the interest that they charge on the home loans they write.

It Is All About The Amortization Schedule

The basics are very simple in lending: Give a lump sum in return for security and accept a series of payments in return. Long ago academics and financiers sat down and established the mathematics of interest rate theory. There is a standard way to measure what is and what is not a good interest-paying investment. One of the principles is that a shorter amortization period, with fewer payments, is more desirable than a longer term; this means a lower rate of interest on the loan.

A similar incentive exists for adjustable rate mortgages. One of the risks of lending funds over extended terms at fixed rates if interest is the danger of missing future opportunities if interest rates rise significantly. So that risk is factored into the rate on fixed loans, and the chance to adjust interest rates means that ARMs have a slightly lower rate, if all other terms are equal.

In practice, the underwriters who originate the loans will usually sell them into the secondary market. Organizations like Fannie Mae and Freddie Mac bundle them together and use the cash flow to securitize the cash flow as bonds.

The stability and value of mortgages as investments matters most to the investors who hold these bonds for the incomes they produce, and so it gives the secondary market an influence over the rate you get offered on the mortgage market. Again, faster repayment means getting investments back sooner and a willingness to accept lower interest payments for lower risk.

Who Is Working For Whom?

Robert Kiyosaki is famous for his books about creating personal wealth. His philosophy is that of differentiating whether you work for your money or your money works for you. When lenders loan cash secured by real estate assets they are putting their money to work. When you borrow to have a home to live in you are the one doing the work. In fact, the connection is that you are working for the lender’s money.

The wealthy approach is to invest in income-producing properties such as real estate and bonds, whereas too many consumers will invest in annuities and reverse mortgages. The difference in the outcomes when you pass is obvious: The former become assets as part of your estate and legacies to your heirs; the latter return to the institutions that issued them.

One of the reasons that consumers have access to mortgage financing is that it is an excellent way for wealthy investors and institutions to earn interest on their capital. When you look at lending from the perspective of investors, you can see that shorter amortization and flexible rates make better investments; it is how they make their wealth work for them rather than the other way around.

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