What is Fixed Rate Mortgage?
A fixed-rate mortgage can be defined as a loan whose interest rate remains constant throughout the term (as compared to the floating rate which adjusts as per the market conditions) and most of the payment is towards the interest in the initial period, whereas, at the end of the term, the majority of the payment is towards the principal amount.
How Does it Work?
In a fixed-rate mortgage, the interest rates remain unchanged throughout the term of the loan and some principal amount is paid every month to ultimately lower the interest payment on the principal amount that is unpaid. The majority of the monthly payment shifts towards the principal amount and in the initial period of the loan, the majority of the payment shifts towards the interest while in the end, the majority of the payment shifts towards the principal.
The types of fixed-rate mortgage are discussed below:
- 40, 30, 15 and 7 Year Mortgages: 40 Year Loan Mortgage happens to be the longest fixed loan mortgage and it is applicable only in the case of residential properties and as a result of the extended pay-off period, it carries the lowest rate of interest. 15 and 30-year mortgages are very common and these carry a higher rate of interest. 15 years and the 7-year mortgage is applicable only in the cases of commercial properties.
- Biweekly Mortgages: Biweekly mortgage payments are generally half of what actually a monthly payment is supposed to be.
- Convertible Mortgages: These are low-interest-rate mortgages that come with a set-up fee.
- Balloon Mortgages: Balloon mortgagesBalloon MortgagesThe Balloon Mortgage calculator computes the amount of balloon balance due at the end of the loan term. It is similar to the outstanding balance formula for a mortgage loan. PV x (1+r)n – P x [(1+r)n – 1 / r]. enable the house owners to pay their loan amount within 5 to 7 years of time.
- Interest-Only Mortgages: These mortgages are very similar to home-equity mortgage loans as the house owner will only be required to pay off the interest amount of the loan.
Example of Fixed Rate Mortgage
Mike wants to buy a home and at the same time, he is looking for a loan option where his interest payment remains constant and does not change over the term of the loan. Mike is willing to make a down payment of $50,000 for a home worth $500,000. He opted for a 5- year fixed rate loan at a 12 percent interest rate. The fixed principle and interest payment that Mike will need to pay on a monthly basis are calculated as below:
- Loan amount = ($500,000 – $50,000) = $450,000
- Number of Payments = Years * Per Year Payment
- Number of Payments = 5 * 12 = 60
- Cumulative PV Factor @1% (12/12) for 60 terms = 44.95503841
- Equated monthly installment = Loan Amount / Cumulative PV Factor @1% (12/12) for 60 terms
- Equated monthly installment = $450,000 / 44.95503841 = $10,010
A fixed-rate mortgage is highly preferred mostly due to the fact that the interest rate here remains fixed for the entire life span of the loan and has the following advantages –
- Ability to Predict Payments: In this type of mortgage, the payment shall remain unchanged throughout the entire term of the loan. The interest rate shall remain totally unaffected with the movements in the market. Even if the payment fluctuation of the service might change, still the interest rate shall remain unvaried.
- Ease in Paying Back Principal Amount: The majority of such mortgages does not really come with prepayment penaltiesPrepayment PenaltiesThe prepayment clause states that if payment is made in advance before the due date, then terms and conditions of the mortgage are not adhered to by the borrower and would be liable to pay the penalty known as the prepayment penalty. that are overly restrictive. This means that the borrowers are able to generate extra payments without any need to pay fees against the principal amount.
- A Stable Rate of Interest: There is hardly any need to pay extra interest when the mortgage market is at its worst. Borrowers can even avail the option of refinancingRefinancingRefinancing is defined as taking a new debt obligation in exchange for an ongoing debt obligation. In other words, it is merely an act of replacing an ongoing debt obligation with a further debt obligation concerning specific terms and conditions like interest rates tenure. to secure better rates if the market starts to get better.
A fixed-rate mortgage has few disadvantages as well and these must also be considered by an individual prior to arriving at the decision of availing this option.
- Expensive Closing Costs: As compared to other loan options, these mortgages can be really expensive since it involves various types of closing costs like discount points, origination fees, underwriting fees, etc. These closing costs can make this loan option really expensive as compared to other loan options.
- Comparatively Higher Interest Rates: The interest rates offered by such mortgage options are higher as compared to other loan options.
- It is not Easy to Qualify for this Loan: Individual with a poor credit rating or who are not that capable of making a higher down payment might face difficulties in securing good deals or grabbing a deal at all since in a fixed-rate mortgage option the closing costs and interest payment is higher.
The fixed-rate mortgage options are a type of mortgage loan where an individual will need to pay a fixed rate of interest for the entire term of the loan. Its types are 40- year mortgages, 30- year mortgages, 15- year mortgages, 7- year mortgages, biweekly mortgages, convertible mortgages, balloon mortgages, and interest-only mortgages.
The advantages of such a mortgage are the predictability of payments, fixed rate of interest, ease of repayment of principal and stable rate of interest. On the other hand, its disadvantages is that there are expensive closing costs like discount points, underwriting fees, origination fees, etc, higher comparable rate of interests, and it is not that easy for individuals with poor credit rating or who are capable and willing of making smaller down payments to qualify for this option. An individual must thoroughly assess his or her situation for determining the type of loan that would best suit him and accordingly choose fixed-rate mortgage options.
This has been a guide to what is Fixed Rate Mortgage and its definition. Here we discuss how does fixed-rate mortgage works along with its types and an example. You can learn more about financing from the following articles –