Fixed Rate Mortgage

As a borrower prepares to buy a home, they will need to decide what type of mortgage is appropriate. If thinking of staying in the home for five to ten years or more, and want payments that will remain constant over the life of the loan, a fixed-rate mortgage may suit their needs.

The following article discusses the fixed-rate mortgage. It explains how it works, and it explains the differences between the various repayment periods that one can choose (10, 15, 20 and 30 years). With this information, the borrower can determine, first, if the fixed-rate mortgage is meets their needs and if it does they can further decide which loan term would best suit their needs.

As the payment comparison table in this article shows, longer-term fixed-rate loans (e.g., the 30-year) have smaller monthly payments, but ultimately cost more in interest. The shorter-term loans (e.g., the 15-year) have larger monthly payments, but they ultimately cost less in interest because of the compressing payments over a shorter period.

Choosing the fixed-rate mortgage will depend on financial needs and goals.

When a borrower is preparing to buy a home, they have many important decisions to make. One of these decisions concerns financing - in particular, what kind of mortgage best serves the borrower's needs?

For most people, the first step in choosing financing is to decide whether to get a fixed-rate mortgage or an adjustable-rate mortgage (ARM).

Fixed-rate mortgages, as their name implies, have interest rates and monthly payments that do not change over the life of the loan. ARMs, on the other hand, have variable interest rates, and the monthly payments fluctuate.

Choose a fixed-rate mortgage or an ARM based on individual circumstances. For example, an ARM may be the right choice if the borrower:

• Plans to stay in the home for a relatively short period of time (for example. seven years or less)
• Wants lower initial monthly payments, and is comfortable with potential, future payment increases
• Wants to qualify for a higher mortgage amount, and expects income to increase over time

Conversely, a fixed-rate mortgage may be the right choice if a borrower:

• Is thinking of staying in the home for at least five to ten years, or more
• Wants payments that will remain constant over the life of the loan

This article focuses on the fixed-rate mortgage, and enables a potential borrower to decide if a fixed-rate mortgage meets their financial needs and goals, by answering the following questions about it:

• What is it?
• How does it work?
• What are the pros and cons?

What is It?

A fixed-rate mortgage is the most common type of loan program. Traditionally, when people have thought of financing a home, they have taken for granted that a fixed-rate mortgage is the way to go. While this thinking has changed more recently because of a wide variety of other options open to borrowers (such as many different types of ARMs), the fixed-rate mortgage remains a popular choice.

Put simply, a fixed-rate mortgage is amortized over a certain period of years, and its monthly principal and interest payment are "locked in" and do not change during that time. A portion of each monthly payment covers the interest due on the loan, while the rest of the monthly payment is applied toward reducing the principal balance. Each monthly payment reduces the loan balance until the loan is paid in full.

Fixed-rate mortgages are available for repayment periods of 30 years, 20 years, 15 years, and 10 years.

The fixed-rate mortgage is appropriate if the borrower:

• Wants stable, predictable monthly payments, and/or
• Plans to live in the home for five to ten years or longer

Furthermore, if the borrower wants a fixed-rate mortgage, they have another decision to make: which loan term best serves their needs? The answer to that question largely depends on whether the borrower:

• Is mainly concerned with having a monthly payment that they know is affordable, or...
• Is mainly concerned with rapid principal paydown and equity build-up

Essentially, the longer-term, fixed-rate mortgage (30 or 20 years) is geared toward the lower monthly payment, while the shorter-term fixed-rate mortgage (15 or 10 years) is geared toward the rapid paydown of principal and buildup of equity.

How does it work?

Fixed-rate mortgages are front-ended. This means that during the early part of the repayment period, a larger percentage of the monthly payment is used to pay the interest than the principal. Hence, the lender makes the most of its profit early on with fixed-rate loans. As the loan is paid down further, more of the monthly payment is applied to principal.

For example, if one has a 30-year fixed mortgage:

• More than 84% of the monthly payment is applied to interest during the first ten years of the loan, and...
• It is not until the 22nd year that 50% of the principal balance is paid off.

With a shorter-term, fixed-rate mortgage, the borrower has a higher monthly payment than with a longer-term loan, but pays less interest and reduces principal faster. Shorter-term, fixed-rate mortgages have a lower interest rate (usually a quarter-percent lower or more) than a longer-term loan, and the borrower is compressing the payments into a shorter period. If the monthly payment is higher, the borrower pays less interest over the life of the loan.

Payment comparison

This table compares what a borrower pays on a $250,000 mortgage with terms of 15 and 30 years. In this illustration the 15-year rate is one-quarter of a percent lower than the 30-year rate. As noted above, this is a typical delta between 30- and 15-year interest rates.

As this example shows, on a $250,000 mortgage, a 30-year loan would cost almost $166,000 more in interest than would a 15-year loan.

If the borrower's main concern is a lower monthly payment, a 30- or 20-year term would be appropriate. The monthly payments are then lower, as the borrower is stretching the payments out over a longer period - although, as noted above, the longer-term loans actually end up costing more because the borrower pays more in interest over the life of the loan.

Conversely, if the concern is payment of less interest, as well as reduction of principal and faster equity build-up, then a 15- or 10-year term may have greater appeal. While the monthly payments would be higher with a 15- or 10-year loan, the borrower builds up equity and pays down principal faster, and pays less interest, than with a 20- or 30-year mortgage.

What are the pros and cons?

As we have seen, the fixed-rate mortgage is an appropriate choice if the borrower plans to stay in the home over a longer period and wants a monthly payment that will stay the same over the life of the loan.

Choosing the fixed-rate mortgage depends on financial needs and goals. If the borrower wants a monthly payment that does not change over the life of the loan, the fixed-rate has appeal to many buyers. Within the fixed-rate, there are choices so that a borrower can pick the loan term that best suits their needs. If the main concern is a lower monthly payment, then a 30- or 20-year loan would meet the borrower's needs. If the main concern were rapid equity build-up and paydown of principal, then the 15- or 10-year loan would meet ones needs.