Not all mortgages are the same. While some borrowers prefer adjustable-rate mortgages (ARMs), the most common fixed-rate mortgage. A fixed-rate mortgage is a mortgage loan with a fixed interest rate for the entire term of the loan. It indicates that your monthly payments will remain the same for the loan duration.
It turns out that you must choose the proper form of mortgage for you. However, before deciding whether a fixed-rate mortgage is right for you, you must first understand the basics of what these mortgages are and how they function.
How Does a Fixed-Rate Mortgage Work?
The rates that mortgage lenders promote are constantly fluctuating due to various variables. As a result, you can get an offer for a 5% interest rate today and a 5.25% rate tomorrow. That movement has no bearing on you if you have a fixed-rate mortgage. Whatever occurs after you get your loan, the interest rate you locked in remains the same.
Your payment amount remains constant, but the distribution of those funds — how much goes toward principal repayment versus interest payments — changes depending on the amortization schedule.
What Are the Benefits of Fixed-Rate Mortgage?
The main advantages of a fixed-rate mortgage are:
- Stable Rates and Payments: With a fixed-rate mortgage, your payments will not change over the life of the loan. It is a significant advantage if you have limited income or are on a tight budget, as it provides stability and predictability for your finances.
- Anti-inflation protection: In times of high inflation, your fixed-rate mortgage protects you from rising prices. As prices increase, your payments stay the same while your purchasing power declines. It is a key benefit if you plan on owning your home for a long time.
- Protection from interest rate increases: A fixed-rate mortgage protects you from interest rate increases. When interest rates go up, your monthly payment stays the same. If interest rates climb dramatically, this can save you a lot of money.
- Help you qualify for a larger loan: With a fixed-rate mortgage, lenders know precisely how much your monthly payment will be, so they can easily qualify you for a loan. That can help if you’re trying to get a loan for a large purchase like a home.
What Are the Downsides of Fixed-Rate Mortgage?
The main disadvantages of fixed-rate mortgages are:
- Higher interest rates: Fixed-rate mortgages usually have higher interest rates than adjustable-rate mortgages. The lender takes on more risk with a fixed-rate loan, as the interest rate will not change even if market conditions do.
- Lower monthly payments in the early years: During a fixed-rate mortgage, your monthly payments will be higher since more of your payment will be directed to interest rather than principal. However, as you near the end of the loan term, your payments will gradually increase as more of the loan is paid off.
- Risk of prepayment penalties: A prepayment penalty may apply if you refinance or sell your house before the end of your loan. The lender imposes this cost, which is often a percentage of the entire loan amount, to cover the interest loss they will incur due to your early repayment.
How Long Do Fixed-Rate Loan Terms Last?
The term of a loan relates to how long you will have to pay it back. The following are the most frequent loan terms for fixed-rate mortgages:
- 30-Year Fixed
- 15-Year Fixed
- 20-Year Fixed
1. 30-Year Fixed
The 30-year loan is the most common type of fixed-rate mortgage. It’s easily the most affordable option since it offers the lowest monthly payments over the life of the loan. The tradeoff is that you’ll pay more interest over the life of the loan because you’re stretched out over a more extended period.
Although borrowers can save money on interest by choosing a shorter-term loan, 30-year loans are frequently the most reasonable option for individuals who are more concerned with keeping their monthly housing bills low than the overall costs over the loan’s duration.
2. 15-Year Fixed
If you can afford the higher monthly payments, a 15-year fixed-rate mortgage is a good choice. The significant advantage of a 15-year mortgage is that it saves you a lot of money in interest charges. You’ll pay off the loan considerably faster and pay less interest because your term is shorter.
The disadvantage is that your monthly payments will be much higher than a 30-year loan. You’ll also have less flexibility if you encounter financial difficulties since you’ll be locked into a higher amount for the life of the loan.
3. 20-Year Fixed
A 20-year fixed-rate mortgage is an excellent middle ground between the longer terms of 30-year and 15-year loans. It will save you money on interest charges while still allowing you to build equity in your home reasonably.
The monthly payments are higher than a 30-year loan but lower than a 15-year loan. And like the 15-year loan, you’ll pay off the debt much faster than with a 30-year mortgage.
The main downside of a 20-year fixed-rate mortgage is that it may be more expensive than other loans in the long run. If you intend to sell your property before the end of the loan term, you may not be able to reclaim all of your interest payments. And if you refinance to a lower rate, you may not save as much money as you would with a shorter-term loan.
How to Calculate Fixed-Rate Mortgage Payments
To calculate your monthly fixed-rate mortgage payment, simply use the following formula:
P = Lx(r/12)x(1+r/12)^n/((1+r/12)^n – 1)
P = your monthly payment
L = the loan amount
r = the interest rate (annual rate/12 to get a monthly rate)
n = the number of payments (months in the loan term)
For example, let’s say you’re buying a home for $200,000 with a 20% down payment. That means your loan amount would be $160,000. And let’s say you get a 30-year fixed-rate mortgage with an interest rate of 4%.
Your monthly payment would be:
P = $160,000x(0.04/12)x(1+0.04/12)^360/((1+0.04/12)^360 – 1)
P = $716.12
To break it down further, your monthly payment would consist of the following:
Principal = $160,000x(0.04/12)x(1+0.04/12)^360/((1+0.04/12)^360 – 1)
Interest = $160,000x(0.04/12)x((1+0.04/12)^360 – (1+0.04/12)^359)/((1+0.04/12)^360 – 1)
Principal = $616.12
Interest = $100
So, each month, you would pay $616.12 in principal and $100 in interest.
What Are the Types of Fixed-Rate Mortgages?
The number of years connected to a fixed-rate mortgage isn’t the only factor to consider. Here’s a list of some terms you’ll find next to fixed-rate loans:
- Conforming
- FHA, VA, USDA
- Conventional
- Amortizing
- Non-conforming
- Non-amortizing
1. Conforming
A conforming fixed-rate mortgage is a loan that meets the guidelines set by the Federal Housing Finance Agency (FHFA). Conforming loans have maximum loan amounts that the government sets.
Conforming loans tend to have lower interest rates because they’re considered low-risk investments for lenders. Borrowers who take out conforming loans are typically more creditworthy than those who take out non-conforming loans.
2. FHA, VA, USDA
FHA, VA, and USDA loans are government-backed loans that typically have lower interest rates than conventional loans. FHA loans are the most commonly available, whereas USDA loans are only available to specific applicants in rural areas. VA loans are only available to military personnel, veterans, and eligible family members.
The main advantage of these loans is that they’re available to borrowers with less-than-perfect credit. The disadvantage is that they usually come with higher interest rates and stricter terms and conditions than conventional loans.
3. Conventional
A conventional loan is a mortgage that the government does not back. These loans have higher interest rates than government-backed loans, but they may be easier to obtain. Banks, credit unions, online lenders, and other lending institutions provide these loans.
4. Amortizing
An amortizing loan has scheduled periodic payments applied to both the principal and the interest. The payments are typically made monthly, and the loan term can range from a few years to several decades.
5. Non-conforming
A non-conforming loan does not comply with the Federal Housing Finance Agency’s (FHFA) criteria. Because lenders consider these loans high-risk investments, they often carry higher interest rates than conforming loans. To qualify, you must meet certain more strict conditions regarding your credit score and financial reserves.
6. Non-amortizing
A non-amortizing loan is a loan that doesn’t have scheduled periodic payments applied to both the principal and the interest. Because lenders consider low-risk investments, these loans often have lower interest rates than amortizing loans. The downside is that you’ll owe the total amount of the loan at the end of the term.
What Are the Differences Between Fixed-Rate and Adjustable Rate Mortgages (Arm)?
Now that you know a little about fixed-rate mortgages, it’s time to compare them with another type of mortgage: adjustable-rate mortgages (ARMs).
Adjustable-rate mortgages (ARMs), which include both fixed- and variable-rate components, are typically offered as an amortized loan with consistent installment payments over the loan’s life. They require a set interest rate for the first few years of the loan, followed by variable interest.
The interest rate is the most significant distinction between these two forms of loans. The interest rate on a fixed-rate mortgage remains constant throughout the loan term. The interest rate on an adjustable-rate mortgage might change over time.
The other key difference is that fixed-rate mortgages are typically available for a shorter term than adjustable-rate mortgages. For example, you might get a 30-year fixed-rate mortgage, but an adjustable-rate mortgage might only be open for a 10- or 15-year term.
What Are the Other Types of Mortgages?
Aside from the type of mortgages mentioned above, there are a few different kinds of mortgages worth mentioning:
- Reverse Mortgage: With a reverse mortgage, you can borrow money against your home’s equity with a reverse mortgage. This type of loan is typically used by seniors who want to stay in their homes but need extra income.
- Interest-Only Mortgage: An interest-only mortgage is a loan wherein you have to pay the interest for a set time. After that, you’ll have to start paying both the principal and the interest. These loans typically have lower monthly payments but can be more expensive in the long run.
- Balloon Mortgage: With a balloon mortgage, you make smaller payments for a particular period and then one large payment at the end of the term. These loans can be riskier because you’re making a large payment at the end, and if you can’t pay the amount, you could lose your home.
- Combination Mortgage: A combination mortgage is a type of loan that lets you choose how you want to structure your payments. For instance, you might make interest-only payments for the first few years and then switch to principal and interest payments. These loans can be customized to fit your unique needs.
- Equitable Mortgage: An equitable mortgage is a type of loan secured by your home but doesn’t have a set term. People generally use these loans while refinancing their homes or taking out a second mortgage.