All home mortgage rates are based upon a standard benchmark known as the real risk free interest rate that must be further adjusted for inflation premium, default risk premium, liquidity premium and maturity premium. These four premiums are integrated by lenders in order to determine mortgage rates. They possess the following characteristics:

- Inflation premium will decrease the anticipated cash flow to the lender over the life of the loan.

- The default risk premium is based upon the quality of the borrower and the risk assumed. For example, a loan made to a sub prime borrower will have a higher default risk premium than a loan made to a prime customer since the lender must take into account the sub prime borrowers’ lower credit ratings and income level.

- The liquidity premium refers to the ease by which a lender can immediately liquidate the balance of a mortgage.
- The maturity premium refers to the amount of time that the lenders’ money will be tied up as an investment.

In accordance with the above factors, home mortgage rates are determined by a simple formula, as follows:

Interest rate = real risk free interest rate + inflation premium + default risk premium + liquidity premium + maturity premium.

When applying this formula to a 30 year fixed rate mortgage, the lender could enter the following standards:

+ 4.5% – real risk free interest rate based on 30 year fixed rate U.S. Treasury Note
+ 0.3% – inflation premium
+ 0.4% – default risk premium
+ 0.5% liquidity premium
+ 0.55% – maturity premium

Interest Rate Determined = 6.25%

It’s important to understand the 3 main types of mortgages in order to determine what option is best.

The first type of mortgage rate is known as the fixed rate because it maintains its interest rate over the life of the loan. The interest rates for these loans are slightly higher than other types of loans but their monthly payments are predictable. During periods of rising interest rates, these mortgages offer protection against higher payments. In short, fixed rate mortgage loans are preferred by home buyers over the other options due to their safety and stability.

Another type of mortgage rate is known as the adjustable rate mortgage (ARM). These mortgages start at a lower rate but fluctuate as market rates change. The typical ARM adjusts once per year according to a specific index such as the average 1 year Treasury Bill rate. ARMS have built in annual and life time caps which can be expensive. ARM loans are popular with borrowers who expect their incomes to rise over the next several years because it allows them to buy more house based on the lower starting interest rates. ARM loans are also popular during periods of falling interest rates.

The last main category of mortgage loan is known as the balloon payment mortgage. These loans are due in 5 to 7 years which means that the mortgage must either be paid off at that time or new financing must be obtained. These loans pose the greatest risk to the borrower, especially if market conditions are not favorable.