Fixed Rate Mortgage Definition
A fixed rate mortgage is a home loan whose interest remains unchanged throughout the loan tenure. The fixed interest rate helps borrowers be aware of the fixed amount they would have to pay at the end of every month. Thus, they can plan their finances and prepare their budget accordingly in the future.
It differs from the variable rate mortgage options, which, when chosen, makes borrowers liable to pay the monthly installments based on the floating interest rates. In this case, the amount payable changes as and when the interest rate fluctuates during the loan term.
Table of contents
- A fixed rate mortgage is a home loan type where the interest rate for the borrowed amount remains the same throughout the loan term.
- It is different from variable rate options, where the interest keeps changing, and adjustable rate alternatives, where the interest remains the same for a specific period and then becomes subject to change.
- Conventional, conforming, and federal housing options are the categories in which these fixed rate home loans are segmented.
- The interest rate and closing cost associated make these options an expensive choice.
How Does Fixed Rate Mortgage Work?
A fixed rate mortgage is a home loan where lenders and borrowers agree upon a specific rate of interest to be paid for the amount, which remains the same throughout the loan term. No matter what fluctuations the market witnesses, it won’t affect the interest rate or the debtor’s monthly repayment amount in any manner.
As these loan options are predictable, most people choose these over variable rate mortgage alternatives, the interest rate of which is subject to change, given the market fluctuations. In addition, the monthly repayment amount is fixed, which makes debtors pay the principal amount monthly and lower the interest payment on the remaining principal. As a result, most of the monthly payment shifts towards the principal amount.
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. Therefore, the fixed rate home loan is considered an amortization loan that reduces the lent amount over the loan term, ranging from a 10 to 15-year fixed rate mortgage to a 30-year fixed rate mortgage, the latter being more common in the United States.
Searching for the best fixed rate mortgage options brings borrowers to a wide range of choices, broadly classified into the following categories:
#1 – Conventional Loans
These home loans are available for anyone with a credit score of 620 and a debt-to-income (DTI) ratio of 43% or less. Though these include stricter requirements, once qualified, the loan seeker can apply for a loan for a term of 10 to 40 years. The lenders that make these conventional loan options available are banks, online lenders, credit unions, etc.
#2 – Conforming Loans
Even stricter in terms of requirements, conforming loans operate according to the Federal Housing Finance Agency (FHFA) regulations. The federal government guidelines help know the loan limit that introduces and makes the options accessible in the secondary market. As these alternatives are insured through Freddie Mac or Fannie Mae, they can be more expensive than the other available loan options.
#3 – Federal Housing Options
Last but not least is the category that includes loan options regulated by the federal housing financiers. Examples of fixed-rate mortgage loans are Federal Housing Administration (FHA) loans, VA loans insured by the US Department of Veteran Affairs, and USDA loans guaranteed by the US Department of Agriculture’s initiative to offer rural housing services. These loan options are available at a lower interest rate and can be acquired with a lower credit score.
Pros & Cons
A fixed rate loan keeps the interest rate the same throughout the loan term. As a result, the monthly payment to be made to the lenders doesn’t change despite the fluctuations in the market. This helps borrowers have accurate budgeting. They know how much they need to keep aside for loan installments, which makes managing finances easier.
The debtors have the liberty to pay back some portions of the principal amount every month to amortize the loan. The best part is that the debtors know how much they must pay every month as there will be no change in that amount throughout the loan period.
Though the interest rate remains the same until the loan period gets over, the same is kept on a higher side. This means the borrowers have to pay more interest for their loans. The major disadvantage is that even if the market is down and the rates decrease for other loan options, fixed rate home loans will still have the same interest payment applicable to borrowers.
The closing cost is more as it includes everything from discount points, underwriting fees, origination fees, etc. As a result, these options might appear expensive.
Let us consider the examples to understand the concept well along with the calculation:
Camelia wanted to apply for a home loan but was confused about which one to go for – a fixed or variable rate loan. So she studied the pros and cons of both options and consulted one of her banker friends. After unveiling the different aspects, she chose the fixed rate loan option.
She knew she might have to pay a higher interest rate, but predictability was the most important thing for her. Camelia knew that she would be aware of her exact monthly liability as it won’t at least go up if not down. Thus, she applied for a 30-year fixed rate loan option.
Mike wants to buy a home. At the same time, he is looking for a loan option where his interest payment remains constant and does not change over the loan term. 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% interest rate. The fixed rate mortgage calculator computes the monthly mortgage payment that Mike will need to pay monthly as below: –
M= P [i (1 + i)n] / [(1+i)n – 1]
P = Principal
i = Interest rate applicable
n = Number of months for the loan term
M = Monthly mortgage payment
Let us put the available values in the expression above:
Mike has already made a down paymentDown PaymentsDown payment is the initial deposit made by the buyer to the seller when purchasing an expensive item, such as residential property or a car. It comprises a portion of the total purchase amount of the asset and takes place via cash, bank check, credit card, or online banking. of $50,000. Thus, the principal amount becomes $450,000
Putting the values for principal, monthly interest, and the number of months in the online calculators will help find how much borrowers need to pay at the end of every month.
Variable vs Fixed Rate Mortgage
The variable rate mortgage products are open to fluctuations, given the changes in the market. However, in this case, as the rate of interest changes, the monthly installment to be paid also changes. As a result, preparing the monthly budget is difficult for people as they are unaware of how much they might need to pay to their creditors.
On the contrary, as stated above, a fixed rate home loan will include the same interest payment until the loan period is over. The interest rate for these options is more than that for variable rate loans, given the predictability factors. The unchanging interest rate makes people opt for these loans despite higher interest rates and closing costs, as they have the benefit of being aware of the amount they will be liable to pay to creditors at the end of every month.
Frequently Asked Questions (FAQs)
A fixed-rate mortgage can be defined as a loan whose interest rate remains constant throughout the loan term (compared to the floating rate, which adjusts according to market conditions). Therefore, most of the payment is towards the interest in the initial period. At the end of the term, most of the clearance is towards the principal amount.
While the fixed rate option keeps the interest rate applicable for the lent amount the same throughout the loan period, the adjustable rate mortgage loan is a hybrid form that combines features of both fixed and variable rate alternatives. This means the interest rate remains unchanged for a specific term, and for the rest of the tenure, it is subject to fluctuations per market conditions.
Yes, it can be refinanced, but the interest rate would not remain the same as it was for the previous contract. Instead, a new agreement with a new interest rate would be signed between lenders and borrowers.
This article is a guide to what is Fixed Rate Mortgage and its definition. Here, we explain its types, examples, and differences with variable rate mortgages. You can learn more about financing from the following articles: –