Mortgages

What Does Fixed Rate Mortgage Mean

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 5 minute read

Home mortgages have a bewildering variety of choices. The fixed-rate mortgage is the most common type because the interest rate remains constant during the loan’s term.

A fixed-rate mortgage guarantees the borrower a constant monthly payment until the loan is repaid. The typical 30-year fixed-rate mortgage is one of the most difficult mortgages to get approved for, despite its predictability. There are drawbacks to acquiring a fixed-rate mortgage, but for certain purchasers, it makes sense.

Knowledge of Fixed-Rate Mortgages

The durability of the Fixed Rate

To most people, a fixed-rate mortgage conjures up images of a loan with a rate that remains constant throughout the loan’s term. Mortgage brokers have been known to mislead many naive homebuyers over the past few years by claiming that a loan is a 30-year fixed-rate mortgage when, in reality, it is just fixed for a portion of that time.

Be sure to ask how long the interest rate will be locked in if you are given a fixed-rate mortgage that seems too good to be true. When the fixed-rate period ends, you may not know what your payments will be like if your mortgage term is 30 years long but the interest rate is only locked in for 5 years.

How to Calculate Your Interest Rate

The interest rate on a fixed mortgage depends on a number of factors, including:

  • Currently Available Interest Rates. A true fixed-rate mortgage has an interest rate that does not fluctuate during the life of the loan like an adjustable-rate mortgage (ARM). Your interest rate will be determined by market conditions at the time of signing.
  • The State of Your Individual Budget. Your rate is based on a number of factors, including your credit history, down payment, and desired loan amount, among others. Remember this while looking at typical mortgage rates on a website like Bankrate, as these will not apply to you.
  • Who Bears the Closing Expenses? Your interest rate can also be modified by including or excluding certain expenses in the rate itself. If, for instance, you want the bank to pay your closing fees, you can agree to a somewhat higher interest rate. The term “no-cost loan” may also apply to this type of loan, but “no-cost” is more prevalent.
  • The insurer of Private Mortgages. The second way a higher rate can work to your advantage is if you opt for lender-paid mortgage insurance rather than purchasing your own (PMI). Once again, the bank will cover the expense of loan insurance in exchange for a higher interest rate, saving you cash.

A Predictable Payment Cost Tradeoff

Although fixed-rate mortgages are the most common type of mortgage, they also often have the highest upfront costs. The bank makes more money with an ARM when interest rates rise, but the bank takes a 30-year risk with a fixed-rate mortgage. 

The bank will lose out on potential profit if interest rates rise after a mortgage has been established, but you will benefit greatly from the change. As a result of the risk of profit erosion, borrowers must factor in a substantial premium for the initial stages of an adjustable-rate mortgage.

Payment Variability

Many homeowners with fixed-rate mortgages are caught off guard when, after several years of paying the same amount every month, they receive a payment that is far higher than they are accustomed to paying. 

This is a regular occurrence for homeowners who opt to have their insurance and property taxes deducted from their monthly escrow payments. With an escrow account, you can pay a portion of your mortgage each month and also a portion of your taxes and insurance. 

Any surplus is transferred to an escrow account. Your mortgage lender will handle disbursing funds from your escrow account to pay your insurance and tax bills when the time comes.

The amount you pay each month doesn’t change, but if your taxes or insurance premiums go up, your mortgage servicer will adjust your payment upward to account for the increase.

Suitability

While a fixed-rate mortgage is a standard, it isn’t necessarily the best choice for every homeowner. In general, those who intend to stay in their current house for several years, or who are refinancing with the intention of staying in their current home, should choose a fixed-rate mortgage while rates are low.

If any of the following apply to you, a fixed-rate mortgage might not be the best option:

  • If interest rates are high where you are, it’s probably not a good idea to lock in at that rate.
  • The initial outlay required by a fixed-rate mortgage may not be worthwhile if you don’t intend to keep the house for at least a few years.
  • If your credit isn’t good, you might not get approved for a loan or get approved at a good rate.
  • Hybrid adjustable-rate mortgages (ARMs) can be easier to qualify for if you can’t afford the high payments of a fixed-rate mortgage right now but expect to have more money soon (for example, after finishing a medical residency).

Pros

There are many advantages to getting a mortgage with a set interest rate:

  1. Trustworthiness of payments. Even if there is a shift in how much you pay your mortgage servicer each month, your monthly payment won’t alter.
  2. Easily applying payments toward principal. You can often make prepayments on a fixed-rate mortgage without incurring any fees.
  3. Fixed Interest Rates. There will be no increase in your interest rate even if the mortgage market takes a major downturn. Furthermore, if conditions improve, you may always refinance to take advantage of a new, lower interest rate.

Cons

Although advantageous, your particular circumstances may dictate that a different type of mortgage is best for you. There are a few reasons why you might decide that a fixed-rate mortgage is not for you:

  1. Large Initial Investment Required. These loans typically have higher origination fees, discount points, and underwriting fees at closing.
  2. In contrast, the interest rate, in this case, is higher. Hybrid adjustable-rate mortgages can be a good option if you don’t plan on staying in the house for a long time because of the lower interest rate they offer.
  3. Tough to Get Accepted Into. Those with less-than-perfect credit or who want to make a lesser down payment can have trouble securing a favorable rate of interest or any rate of interest at all due to the increased monthly payment and the higher closing costs.

Bottom Line

The 30-year fixed-rate mortgage is still the most common type of loan taken out, but the added peace of mind that comes with it comes at a higher initial cost than that of an adjustable-rate mortgage. 

Additionally, many Americans don’t stay in their homes long enough to reap the benefits of a fixed-rate mortgage because of the rising mobility of American families. Make sure you shop around for the best loan terms by contacting different lenders before making a final decision.

Curated posts

Someone from Indianapolis, IN just viewed Best Online Colleges for Exercise Science