What is a fixed-rate mortgage?
A fixed-rate mortgage charges a set interest rate that doesn’t change during the term of the loan. The total payment of a fixed-rate mortgage remains stable, even though the amount of principal versus interest paid varies with each payment.
Fixed-rate mortgages are generally offered as amortized loans with installment payments. However, non-amortizing loans can also be issued with a fixed rate. There are varying risks involved for both borrowers and lenders, which are usually centered around the interest rate environment. In a time of rising rates, for example, a fixed-rate mortgage offers lower risk for a borrower and higher risk for a lender. Borrowers typically want to lock in lower interest rates to save on costs over time.
When rates are rising, interest rate risk is higher for lenders. They forego profits from loans that could earn higher interest over time in a variable rate scenario.
A 30-year, fixed-rate mortgage is most attractive to real estate investors because it offers the lowest monthly payment. However, the low payments lead to significantly higher costs over the life of the loan due to the additional decade or more added to the term.
Fixed- vs. adjustable-rate mortgages
Fixed-rate mortgages and adjustable-rate mortgages (ARMs) are the two primary mortgage types, although banks do offer numerous varieties of the above.
The interest rate for an adjustable-rate mortgage is variable: Initially, it’s often set below the market rate for a comparable fixed-rate loan. The rate rises as time goes on. If the ARM is held long enough, the interest rate will likely surpass the going rate for fixed-rate loans.
ARMs have a fixed period during which the initial interest rate remains constant. After that, the interest rate adjusts at a pre-arranged frequency. The fixed-rate period can vary significantly—anywhere from one month to 10 years. Shorter adjustment periods generally carry lower initial interest rates.
After the initial term, the loan resets, meaning there is a new interest rate based on current market rates. This is then the rate until the next reset, which may be the following year.
There are several types of adjustable-rate mortgages available. A 5/1 ARM has an introductory rate of five years. After that first five-year period expires, the interest can change annually. A 5/5 ARM features a fixed period for five years, with a change allowed every five years after the initial period. Another type is the 2/28 ARM. In this form, a fixed rate remains in place for two years. Then, a floating rate occurs over the next 28 years.
Interest rates for fixed-rate mortgages
Fixed-rate mortgages have a fixed interest rate for the loan’s entire term. The main advantage of a fixed-rate loan is that the borrower is protected from sudden and potentially significant increases in monthly mortgage payments if interest rates rise.
Fixed-rate mortgages are easy to understand and vary little from lender to lender. The downside to fixed-rate mortgages is that when interest rates are high, qualifying for a loan is more difficult because the payments are less affordable.
Although the rate of interest is fixed, the total amount of interest you’ll pay depends on the mortgage term. Traditional lending institutions offer fixed-rate mortgages for a variety of terms, the most common of which are 30, 20, and 15 years.
Interest rate trends have been declining since the mid-1980s. That’s because inflation has been under control since then, thanks to expansionary monetary policies of the U.S. Federal Reserve. We’ve seen relatively low rates on Treasury bonds for decades. As a result, the interest rates on 30-year fixed rate mortgages have been below 7% since March 2002.
Fixed-rate mortgage pros and cons
The biggest advantage of a fixed-rate mortgage loan is that the interest rate is locked in for the term of the loan. It doesn’t matter if interest rates rise or fall.
Although adjustable-rate mortgages typically have several caps that determine how much the interest rate can rise, a rate hike of just a few percentage points can be burdensome for many borrowers.
Adjustable-rate mortgages caused problems during the subprime mortgage meltdown of 2008. Borrowers embraced ARMs before the crisis, drawn to the initial lower monthly payment. Then borrowers saw their ARMs adjust and their payments inflate.
Conversely, a fixed interest rate and stable payments allow you to budget for your monthly mortgage payment and not lose sleep over rising interest rates.
The downside to fixed-rate mortgages is that if interest rates fall, your mortgage rate won’t automatically fall along with it. Instead, to take advantage of lower rates, you must refinance, which means paying closing costs.
Opting for an adjustable-rate mortgage means the interest rate on the loan would have fallen with the drop in rates. But just as there are caps on how high an adjustable rate can climb, most will also have a cap on how low the rate can fall.
When to choose an adjustable-rate mortgage
The main reason to consider adjustable-rate mortgages is that you may end up with a lower monthly payment. The bank “rewards” borrowers with a lower initial rate because they’re taking the risk that interest rates could rise in the future. Meanwhile, with a fixed-rate mortgage the bank takes the risk. If rates rise, the bank is stuck with a loan at below-market rates.
While you may benefit from a lower payment, you still have the risk that rates will rise. If that happens, your monthly payment can increase dramatically. What was once an affordable payment can become a serious burden when you have an adjustable-rate mortgage. The payment can get so high that you have to default on the debt.