Fixed-rate mortgages can either be conventional loans or loans guaranteed by the Federal Housing Authority (FHA) or the Department of Veterans Affairs.
How a Fixed-Rate Mortgage Works
Each month’s payment is equal to the interest rate times the principal, plus a small percentage of the principal itself. The process of paying the loan over time is called amortization. Since a bit of the principal is paid off each month, that makes the interest payment on the remaining principal a little less too. As a result, more of your monthly payment goes toward the principal each month. In other words, most of the monthly payment goes toward interest at the beginning of the loan. Toward the end, most of it goes toward the principal. See how far your monthly payments go towards paying the interest and returning the principal balance over time using our loan amortization calculator.
How Interest Rates Are Determined
The interest rate is usually just a little higher than the yield of the 30-year Treasury bond at the time the mortgage is issued. Investors buy mortgages on the secondary market when they are looking for something that provides more of a return than Treasurys without adding too much risk. That’s how Treasury notes affect mortgage rates. Interest rates have generally been on the decline since 1985. One reason is that the Federal Reserve has kept inflation under control since then. That’s led to low rates on Treasury bonds. As a result, the interest rates on 30-year fixed-rate mortgages have been below 7% since March 2002. As of Sept. 11, 2020, the average 30-year fixed mortgage rate is 2.86%, which is an all-time low. The chart below illustrates the change in interest rates between 15-year and 30-year fixed-rate mortgages, spanning the year 2000 up until today.
Types of Fixed-Rate Mortgages
There are three types of fixed-rate mortgages.
5/1 Adjustable Rate Mortgage
A 5/1 adjustable-rate mortgage (ARM) starts with a five-year fixed-rate mortgage. After the first five years, it then varies according to prevailing interest rates. The advantage is that the initial interest rate is lower than on a 30-year mortgage. The disadvantage is what happens after five years. Your interest rate could increase rapidly, depending on current rates. This may be a good loan if you’re planning to sell within five years or if you believe interest rates will decline.
15-Year Mortgage
A 15-year fixed-rate mortgage has a fixed rate for the entire 15 years of the loan. It may be attractive to homeowners because you pay off more of the principal with each payment. That means you can pay off the principal faster than with a conventional 30-year loan. You also build up equity faster. On the other hand, 15-year mortgages have higher monthly payments. For that reason, there’s a slightly higher risk of default if your income drops.
30-Year Mortgage
A 30-year mortgage is the most affordable conventional loan. The monthly payment is lower than the 15-year loan because the repayment is spread out over 30 years. This may be a good loan if you plan to stay in your home for a long time. It’s also good for families with lower incomes because it allows them to buy a home with a lower monthly cost.
Conforming Loans
Conforming loans have a maximum amount set by the federal government. The government insures them either through Freddie Mac or Fannie Mae. As a result, they can be a little less expensive than nonconforming loans.
FHA Loans
FHA mortgages are regulated and insured by the Federal Housing Administration. Borrowers can have lower credit scores and pay less for the down payment than a conventional loan.
Alternatives to Fixed-Rate Mortgages
Alternatives to a fixed-rate mortgage include adjustable rate mortgages where the interest rate can change over time, or a no-cost loan, which is really where the closing costs are rolled into the loan itself. You could end up paying more over the life of the loan with the latter because you are paying interest on those closing costs. You could also pay more with an adjustable-rate mortgage if the rate increases after the fixed-rate period. If the rate decreases though, you could end up saving money on your monthly payments.
Pros and Cons of Fixed-Rate Mortgages
Pros Explained
The advantage of the fixed-rate mortgage is that the payment is the same each month. This predictability makes it easier to plan your budget. You don’t have to worry about future higher payments as you do with an adjustable-rate mortgage. You pay off a little of the principal each month. That automatically increases your home equity. The only reason your monthly payment might increase is if you pay your real estate taxes through your monthly mortgage payment and taxes increase, or your home insurance goes up. You can make extra payments to pay off your principal earlier. Most fixed-rate loans don’t have pre-payment penalties. It’s may also be a great loan if you think interest rates will go up over the next several years. That’s because your rate is locked-in and won’t change unless you choose to refinance.
Cons Explained
The disadvantage of a fixed-rate mortgage is that the interest rate may be higher than either an adjustable-rate loan or interest-only loan. That makes it more expensive if interest rates remain the same or fall in the future. Another disadvantage is that you pay off the principal at a slower rate than with an adjustable-rate loan. The payments over the first few years primarily go toward interest. Therefore, these are not good if you plan to sell your house within five to 10 years. It also may be difficult to qualify for fixed-rate loans and you could pay higher closing costs than for an adjustable-rate loan. Both of these are because banks may lose money if rates go up. That’s a big risk for them to take for a 30-year loan because banks want to be paid to cover that risk. If you plan to move in five years or less, an adjustable-rate mortgage may be a better fit.
How to Get a Fixed-Rate Mortgage
You can apply for a fixed-rate mortgage at almost any bank, credit union, or mortgage lender. It’s best to compare rates among companies. The Consumer Financial Protection Bureau (CFPB) has a great tool to help you explore interest rates. You should also compare fees, points, and closing costs. Check to see if mortgage insurance is required, too. For your own protection, ask for a qualified mortgage. It will protect you from dangerous features such as negative amortization, balloon payments, and excess points and fees.
