Definition of a fixed rate mortgage


What is a fixed rate mortgage?

The term “fixed rate mortgage” refers to a home loan that has a fixed interest rate for the entire term of the loan. This means that the mortgage has a constant interest rate from start to finish. Fixed-rate mortgages are popular products for consumers who want to know how much they will pay each month.

Key takeaways

  • A fixed rate mortgage is a home loan with a fixed interest rate for the entire term of the loan.
  • Once set, the interest rate does not fluctuate with market conditions.
  • Borrowers who want predictability and those who tend to own long-term properties tend to prefer fixed-rate mortgages.
  • Most fixed rate mortgages are amortized loans.
  • Unlike fixed-rate mortgages, there are adjustable-rate mortgages, whose interest rates change during the course of the loan.

How a Fixed Rate Mortgage Works

There are several types of mortgage products available on the market, but they fall into two basic categories: variable loans and fixed rate loans. With variable rate loans, the interest rate is set above a certain benchmark and then fluctuates, changing over certain periods.

Fixed rate mortgages, on the other hand, carry the same interest rate throughout the life of the loan. Unlike variable and adjustable rate mortgages, fixed rate mortgages do not fluctuate with the market. Therefore, the interest rate on a fixed-rate mortgage remains the same regardless of where interest rates rise or fall.

Adjustable rate mortgages (ARMs) are a kind of hybrid between fixed and variable loans. An initial interest rate is fixed for a period of time, usually several years. After that, the interest rate is reset periodically, at annual or even monthly intervals.

Most mortgages who buy a long-term home end up locking in an interest rate with a fixed mortgage. They prefer these mortgage products because they are more predictable. In short, borrowers know how much they are expected to pay each month, so there are no surprises.

Fixed rate mortgage terms

The term of the mortgage is basically the useful life of the loan, that is, the time you have to make payments.

In the US, terms can range from 10 to 30 years for fixed-rate mortgages – 10, 15, 20, and 30 years are the usual increments. Of all the term options, 30 years is the most popular, followed by 15 years.

The 30-year fixed-rate mortgage is the product of choice for nearly 90% of today’s homeowners.

How to Calculate Fixed Mortgage Rate Costs

The actual amount of interest paid by borrowers with fixed-rate mortgages varies based on how long the loan is amortized (that is, how long the payments are spread out). While the mortgage interest rate and monthly payment amounts themselves don’t change, the way your money is applied does change. Mortgages pay more for interest in the initial stages of repayment; later on, your payments will go more toward the loan principal.

Therefore, the term of the mortgage comes into play when calculating mortgage costs. The basic rule: the longer the term, the more interest you pay. Someone with a 15-year term, for example, will pay less interest than someone with a 30-year fixed-rate mortgage.

Doing the math can be a bit tricky – to determine exactly what a particular fixed-rate mortgage costs, or to compare two different mortgages, it’s easiest to use a mortgage calculator. Enter a few details, typically the house price, down payment, loan terms, and interest rate, hit the button, and get your monthly payments. Some calculators will itemize them, showing what goes into interest, what goes into principal, and even (if indicated) property taxes; They will also show you a general amortization schedule, illustrating how those amounts change over time.

For lovers of mathematics

If you like numbers, there is a standard formula for manually calculating your monthly mortgage payment.

where:

SUBWAY= Monthly payment

P= Principal amount of the loan (the amount you are borrowing)

I= Monthly interest rate

North= Number of months required to repay the loan

So, to solve for the monthly mortgage payment (“M”), enter the principal (“P”), the monthly interest rate (“i”), and the number of months (“n”).

If you just want to calculate mortgage interest, here is a quick formula for that:

Special Considerations

Most amortized loans have fixed interest rates, although there are cases where non-amortizing loans also have fixed rates.

Amortized Loans

Fixed-rate amortized home loans are among the most common types of mortgages offered by lenders. These loans have fixed interest rates for the life of the loan and fixed installment payments. A mortgage loan with fixed rate amortization requires the lender to create a base amortization schedule.

You can easily calculate a repayment schedule with a fixed interest rate when a loan is issued. That’s because the interest rate on a fixed-rate mortgage doesn’t change for every installment payment. This allows a lender to create a payment schedule with constant payments throughout the life of the loan.

As the loan matures, the repayment schedule requires the borrower to pay more principal and less interest with each payment. This differs from a variable rate mortgage where a borrower has to deal with different loan payment amounts that fluctuate with interest rate movements.

Unamortized loans

Fixed-rate mortgages can also be issued as non-amortizing loans. These are generally known as balloon payment loans or interest-only loans. Lenders have some flexibility in structuring these alternative fixed-rate loans.

A common structure for balloon payment loans is to charge annual deferred interest to borrowers. This requires that interest be calculated annually based on the borrower’s annual interest rate. The interest is then deferred and added to a balloon payment at the end of the loan.

In a fixed-rate-only loan, borrowers pay only interest on scheduled payments. These loans generally charge monthly interest based on a fixed rate. Borrowers make monthly interest payments with no principal payment required until a specified date.

Fixed rate mortgages versus adjustable rate mortgages (ARM)

Adjustable rate mortgages (ARMs), which have both fixed and variable rate components, are also generally issued as an amortized loan with constant installment payments over the life of the loan. They require a fixed interest rate in the first few years of the loan followed by a variable interest rate after that.

Repayment schedules can be a bit more complex with these loans, as the rates on a portion of the loan are variable. Therefore, investors can expect to have variable payment amounts rather than consistent payments like with a fixed rate loan.

Adjustable rate mortgages are generally favored by people who don’t mind the unpredictability of rising and falling interest rates. Borrowers who know they will refinance or not keep the property for an extended period also tend to prefer ARMs. These borrowers often bet that rates will go down in the future. If rates fall, the borrower’s interest decreases over time.

Advantages and disadvantages of a fixed rate mortgage

There are various risks involved for both borrowers and lenders in fixed-rate home loans. These risks tend to focus on the interest rate environment. When interest rates go up, a fixed rate mortgage will have lower risk for a borrower and higher risk for a lender.

Borrowers generally look to lock in lower interest rates to save money over time. When rates go up, a borrower keeps a lower payment compared to current market conditions. A lending bank, on the other hand, is not earning as much as it could from the prevailing higher interest rates; forego the proceeds from the issuance of fixed-rate mortgages that could be earning higher interest over time in a variable-rate scenario.

In a market with falling interest rates, the opposite occurs. Borrowers are paying more on their mortgage than current market conditions dictate. Lenders are making higher profits on their fixed-rate mortgages than they would if they had to issue fixed-rate mortgages in today’s environment.

Of course, borrowers can refinance their fixed-rate mortgages at the prevailing rates if they are lower, but they have to pay significant fees to do so.

www.investopedia.com

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Mark Holland

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