What is a fixed rate mortgage?
The term “fixed rate home loan” refers to a home loan with a fixed interest rate for the entire term of the loan. This means that the mortgage carries a constant interest rate from start to finish. Fixed rate mortgages are popular products for consumers who want to know how much they will be paying each month.
Key points to remember
- A fixed rate home loan is a home loan at a fixed rate for the life of the loan.
- Once locked in, the interest rate does not fluctuate with market conditions.
- Borrowers who seek predictability and / or tend to hold property for the long term tend to prefer fixed rate mortgages.
- Most fixed rate mortgages are amortized loans.
- Unlike fixed rate mortgages, there are adjustable rate mortgages, the interest rates of which change over the course of the loan.
How a fixed rate mortgage works
There are several types of mortgage products available in the market, but they boil down to two basic categories: variable rate loans and fixed rate loans. With variable rate loans, the interest rate is set above a certain benchmark and then fluctuates, changing at certain times.
Fixed rate mortgages, on the other hand, carry the same interest rate throughout the life of the loan. Unlike adjustable and adjustable rate mortgages, fixed rate mortgages do not fluctuate with the market. So the interest rate on a fixed rate mortgage stays the same no matter where the interest rates go up or down.
Variable rate mortgages (ARMs) are somewhat of a hybrid between fixed and variable rate loans. An initial interest rate is set for a period of time, usually several years. After that, the interest rate is reset periodically, at annual or even monthly intervals.
Most mortgagors who buy a home for the long term end up locking in an interest rate with a fixed rate mortgage. They prefer these mortgage products because they are more predictable. In short, borrowers know how much they will have to pay each month, so there are no surprises.
Fixed rate mortgage conditions
The term of the mortgage loan is basically the life of the loan, that is, the length of time you have to make the payments.
In the United States, 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 futures options, the most popular is the 30-year option, followed by 15-year.
The 30-year fixed rate mortgage is the product of choice for nearly 90% of homeowners today.
How to calculate the costs of a fixed rate mortgage
The actual amount of interest borrowers pay with fixed rate mortgages varies depending on the length of the loan amortization (that is, the length of the payments period). While the interest rate on the mortgage and the monthly payment amounts themselves don’t change, the way your money is used does. Mortgages pay more interest in the early stages of repayment; later, their payments go more into the principal of the loan.
Thus, the term of the mortgage comes into play when calculating mortgage costs. The rule of thumb: the longer the term, the more interest you pay. A person with a 15-year term, for example, will pay less interest than a person with a 30-year fixed rate mortgage.
Calculating the numbers can be a bit tricky: To figure out exactly what a fixed rate mortgage costs, or to compare two different mortgages, it’s easier to use a mortgage calculator.
You enter a few details, usually the house price, down payment, loan terms, and interest rate, press the button, and receive your monthly payments. Some calculators will break them down, showing what goes to interest, principal, and even (if you call it that) property taxes; they will also show you an overall amortization schedule, which illustrates how these amounts have changed over time.
If you like numbers, there is a standard formula for manually calculating your monthly mortgage payment.
M= Monthly payment
P= Principal loan amount (the amount you borrow)
I= Monthly interest rate
m= Number of months required to repay the loan
So, to resolve the monthly mortgage payment (“M”), you plug in the principal (“P”), the monthly interest rate (“i”) and the number of months (“n”).
If you want to calculate mortgage interest on your own, here’s a quick formula for it:
Most amortized loans have fixed interest rates, although there are cases where non-amortizing loans have fixed rates as well.
Amortized fixed rate mortgages are among the most common types of mortgages offered by lenders. These loans have fixed interest rates over the life of the loan and regular payments. A fixed rate amortizing mortgage loan requires a basic amortization plan to be generated by the lender.
You can easily calculate an amortization schedule with a fixed interest rate when issuing a loan. This is because the interest rate on a fixed rate mortgage does not change with each payment. This allows a lender to create a payment schedule with constant payments over the life of the loan.
As the loan matures, the amortization schedule forces 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 variable loan repayment amounts that fluctuate with changes in interest rates.
Fixed rate mortgages can also be issued as unamortized loans. These are generally referred to as lump sum loans or interest only loans. Lenders have some flexibility in how they can structure these alternative fixed interest rate loans.
A common structure for lump sum loans is to charge borrowers annual deferred interest. This requires that the interest be calculated annually based on the borrower’s annual interest rate. The interest is then deferred and added to a lump sum payment at the end of the loan.
In an interest-free fixed rate loan, borrowers only pay interest on scheduled installments. These loans usually charge monthly interest based on a fixed rate. Borrowers make monthly interest payments, with no principal payment required by a specified date.
Fixed rate mortgages versus variable rate mortgages (ARMs)
Variable Rate Mortgages (ARMs), which have both fixed and variable rate components, are also typically issued as an amortized loan with regular payments over the life of the loan. They charge a fixed interest rate for the first few years of the loan, followed by a variable interest rate thereafter.
The amortization schedules can be slightly more complex with these loans because the rates for a portion of the loan are variable. Thus, investors can expect variable payment amounts rather than consistent payments with a fixed rate loan.
ARMs are generally preferred by people who don’t mind the unpredictability of rising and falling interest rates. Borrowers who know they will refinance or not hold the property for a long time also tend to prefer ARMs. These borrowers usually bet on lower rates in the future. If rates go down, a borrower’s interest goes down over time.
Pros and Cons of a Fixed Rate Mortgage
Variable risks are involved for both borrowers and lenders in fixed rate mortgages. These risks are generally centered on the interest rate environment. When interest rates rise, a fixed rate mortgage presents lower risk to a borrower and higher risk to a lender.
Borrowers typically look to lock in lower interest rates to save money over time. When rates rise, a borrower maintains a lower payment compared to current market conditions. A lending bank, on the other hand, does not pull as much as it could from the higher prevailing interest rates, forgoing the benefits of issuing fixed-rate mortgages that could earn higher interest over time. in a variable rate scenario.
In a market where interest rates are falling, the opposite is true. Borrowers are paying more on their mortgage than current market conditions allow. Lenders are making higher profits on their fixed rate mortgages than they would if they were to issue fixed rate mortgages in today’s environment.
Of course, borrowers can refinance their fixed rate mortgages at going rates if those rates are lower, but they have to pay a significant fee to do so.