What is a Fixed Rate Mortgage?
The term “fixed-rate mortgage” refers to the type of loan in which the interest rate doesn’t change during the entire tenure of the loan. Unlike variable and adjustable-rate mortgages, a fixed-rate mortgage carries the same interest rate over the loan’s entire life and doesn’t fluctuate with the market. In other words, the interest rate in the case of a fixed-rate mortgage remains the same irrespective of whether interest rates in the market increase or decrease. Typically, borrowers prefer fixed rates for long-term mortgage loans to accurately predict future costs and payments.
How does Fixed Rate Mortgage work?
The choice of a fixed-rate mortgage depends on two factors – loan tenure and the current interest rate environment. This is immune to any kind of changes in the economy, which is desirable in the case of a long-term loan. Let us understand the concept in more detail with the help of the following illustration.
Let us assume that the current interest rate in the market is low but is expected to surge in the near future. In such a scenario, it is favored over a variable rate mortgage as the former locks the loan at the prevailing lower interest rate and protects the mortgagor from the brunt of increased interest expense due to future changes. However, if the interest rate in the market is expected to go down in the future, then taking a fixed-rate mortgage will become an expensive option.
Types of Fixed Rate Mortgage
The following are the most common types of fixed-rate mortgage loans:
- 30-year fixed rate mortgage: It is the most popular choice for mortgagors as the long tenure of the loan means that the periodic payments are relatively low, even with a slightly higher interest rate. However, the mortgagors can save more money on interest expenses by opting for a shorter-term loan.
- 15-year fixed rate mortgage: The borrowers who opt for a 15-year fixed rate mortgage are able to save quite a bit of money on interest. The savings happen for two reasons – 15-year mortgages are typically available at lower interest rates than 30-year mortgages, and the shorter amortization period results in lower interest payouts. The second point holds good even when the interest rates are the same on both 15-year and 30-year mortgages.
How are fixed rates determined?
Typically, the fixed rates have maintained a touch higher than the yield of the 30-year Treasury bonds prevalent at the time of the mortgage issuance. The reason is that these mortgages are traded in the secondary market by investors who look for slightly higher returns than the Treasury bonds without assuming any additional risk. As of September 27, 2021, the average 30-year mortgage rate is 3.37%, and the 15-year mortgage rate is 2.81%.
The most popular alternative is an adjustable-rate mortgage in which the interest rate changes over time. Of course, the borrower would end up paying more with an adjustable-rate mortgage if the interest rate in the market increases over the period. However, in a falling interest rate environment, the borrower would save quite a bit of money on the monthly payments.
Some of the major advantages are as follows:
- Since the payments remain unaffected by the movements in the market in these types of mortgages, the borrowers are able to predict the payments well in advance and plan the cash outflow accordingly.
- Most fixed-rate mortgages don’t come up with prepayment penalties, which enhances the ease of paying back the principal. This means that the borrowers can repay more than the scheduled payments without incurring any extra fees or penalties.
- It is the best option in an increasing interest rate environment as there is no need to pay any extra interest even at a time when the loan market is at its worst.
Some of the major disadvantages are as follows:
- These mortgages can be expensive compared to other loan options as the former involves different closing costs, such as underwriting fees, origination fees, etc.
- The interest rates charged for fixed-rate mortgages are relatively higher than the other loan options.
- It is very difficult to qualify for a fixed-rate mortgage. Typically, an individual with a poor credit rating might find it really difficult to secure a good deal or even grab a deal at all.
Some of the key takeaways of the article are:
- As the name suggests, it is a type of loan in which the interest rate remains the same for the entire term of the loan. In other words, the interest rate doesn’t fluctuate with the market conditions.
- Borrowers who seek better predictability of the future payments and are willing to hold the underlying property for a longer period of time tend to prefer fixed-rate mortgages.
- A fixed-rate mortgage is considered the best option in an increasing interest rate environment as there is no need to pay any extra interest.
So, it can be seen that a fixed-rate mortgage is great for the stability of cash outflow. It makes a lot of sense in a volatile market situation as the borrower doesn’t need to worry about the impact of changing economic conditions on the periodic payments. Ultimately, the mortgage loan choice largely depends on the borrower’s financial situation and desire for stable future payments.
This is a guide to Fixed Rate Mortgage. Here we also discuss the definition, working, types, and alternatives along with the advantages and disadvantages. You may also have a look at the following articles to learn more –