When you take out a mortgage to purchase a home, you have hundreds of lenders and dozens of different loan products to choose from. Even with all this variety, all mortgage loans fit into one of two categories -- fixed or adjustable rate.
Fixed-rate mortgage loans are by far the more common of the two. In this article, we'll take a look at what fixed-rate mortgages are, how they work, and who should get a fixed-rate mortgage.
A fixed-rate mortgage is a type of loan based on real estate, with an interest rate that remains constant for the entire term of the loan.
For example, let's say you get a 30-year mortgage with a fixed interest rate of 4.00%. This mortgage rate will be used to calculate the interest accumulation on your loan for the entire 30-year repayment period.
Each month, your mortgage payment will be the same with a fixed-rate mortgage. Your interest rate will not change over the life of the loan. It determines how much interest you'll pay as a percentage of your loan's outstanding principal balance.
However, the portion of the payment that is applied towards principal changes each month. This is because of a concept known as amortization. As the principal decreases over time, less interest will accumulate between payments. As time goes on, more of each payment will be applied to the principal.
Generally speaking, the longer the loan term of a fixed-rate mortgage, the higher the interest rate, all other factors being equal. In other words, the average borrower will pay a higher interest rate on a 30-year fixed-rate mortgage than a 15-year fixed-rate mortgage. And a 20-year mortgage would have an interest rate in between the two.
An example: If you borrow $200,000 at 4.00% interest for 30 years, your monthly payment will be $955. Based on your $200,000 balance, interest will accumulate at the rate of $8,000 per year, or about $667 per month. Therefore, your first mortgage payment will be made up of $667 in interest, with the other $288 applied to the principal.
There are two main types of home loan you can get: fixed rate or adjustable rate. We've already discussed how a fixed-rate mortgage works.
The short explanation of an adjustable-rate mortgage is that its interest rate can change over time. An adjustable-rate mortgage will typically have a low initial interest rate that is fixed for a certain number of years. It will adjust according to a certain benchmark annually after the initial period expires. For example, a 5/1 adjustable-rate mortgage would have the same interest rate for the first five years. It would adjust annually after the initial five-year period is over.
An adjustable-rate loan is also commonly called a variable-rate loan.
The biggest advantage of using a fixed-rate mortgage is that it keeps your monthly mortgage payment consistent. Other monthly costs -- such as insurance, property taxes, and HOA fees (if applicable) -- can and probably will change over time. But a fixed-rate mortgage prevents the principal and interest portion of your payment from fluctuating.
Fixed-rate mortgages make the most sense for borrowers who intend to live in their homes for a long time. They will get the most value out of keeping their payments constant.
It's also worth noting that during low-interest periods, fixed-rate mortgage rates can actually have a lower interest rate than the initial adjustable-rate mortgage rates. In fact, as of Jan. 28, 2021, the average interest rate for a 15-year mortgage and a 30-year fixed-rate mortgage was 2.2% and 2.73%, respectively. The average interest rate for a 5/1-year adjustable-rate loan was 2.8%, according to Freddie Mac.
Normally -- outside of low-interest periods -- the initial interest rate available on adjustable-rate mortgages is lower than the fixed-rate average. In other words, borrowers can usually get a lower initial monthly payment with an adjustable-rate loan.
If this is the case, an adjustable-rate mortgage can make more sense for a borrower who doesn't plan on owning the home beyond the initial rate resets.
Here are some important terms that can be especially important for fixed-rate mortgage borrowers:
Annual percentage rate (APR). You'll typically receive two interest rate percentages when applying for a mortgage. The loan's interest rate just tells you the interest you'll pay on an annual basis as a percentage of your principal balance. On the other hand, annual percentage rate (APR) tells you the true cost of borrowing, including lender fees.
PITI. PITI stands for principal, interest, taxes, and insurance. Many lenders require borrowers to pay property taxes and homeowners insurance along with their monthly mortgage payments. As such, your PITI is often your mortgage's actual monthly cost.
Amortization. This is the process by which your loan payments are spread out over time. In other words, amortization determines how much of your loan payments will go towards principal and how much will be applied to interest. Over time, your mortgage payments will contain less interest and more principal.
Rate lock. Once you fill out a mortgage application and get a quote, you have the ability to lock your mortgage rate. In other words, let's say you get approved for a 30-year fixed-rate loan at 3% interest and rates quickly spike to 4% before you close. If you had locked your rate, you'd still pay 3%.
Discount points. When you obtain a mortgage, paying discount points can help get you a lower rate. One "point" is equal to 1% of the amount you're borrowing. As of January 2021, the average fixed-rate mortgage borrower pays 0.7% of their loan in points and lender fees.
A fixed-rate mortgage is a type of home loan with an interest rate that remains constant for the entire term of the loan.
A fixed-rate mortgage has a monthly principal and interest payment that remains constant throughout the loan's term.
The interest rate on an adjustable-rate mortgage can change at certain intervals (usually once a year). The changes are based on a certain benchmark interest rate.
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