What Is A Fixed-Rate Mortgage, And How Does It Work?
When you begin the home buying process, you’ll hear the term “fixed-rate mortgage” thrown around a lot. But what is a fixed-rate mortgage, and how does it work?
A fixed-rate mortgage has a rate that won’t change over the life of the loan. If you’re looking to buy a house, a fixed-rate mortgage is a good option because your monthly payment will stay the same.
But different types of mortgages are appropriate for different situations. This article will explain more about fixed-rate mortgages so you can find the option that’s best for you.
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Fixed-Rate Mortgage Definition
A fixed-rate mortgage is a home loan with an interest rate that stays the same throughout the life of the loan. When you lock in your loan, the rate you receive will remain the same the entire time you’re paying off your mortgage.
There are many advantages to taking out a fixed-rate mortgage. A steady interest rate means your monthly payments will stay the same from month to month.
For that reason, fixed-rate mortgages make up the majority of U.S. mortgages. If you’re unsure of what type of mortgage you have, odds are it’s a fixed-rate mortgage.
Adjustable- Vs. Fixed-Rate Mortgage
When you’re applying for a mortgage, another option is to take out an adjustable-rate mortgage (ARM). Unlike fixed-rate mortgages, ARMs have interest rates that change based on market conditions.
There are several different types of ARMs you can apply for, like a 5/6, 7/6 or 10/6. If you apply for a 5/6 ARM, you’ll receive a low introductory rate for the first 5 years, and then your rate will adjust every 6 months.
ARMs are more complex than fixed-rate mortgages. Once your introductory period is up, your lender will use an interest rate index to determine how your rate will change.
Unlike fixed-rate mortgages, you can’t predict what your payments can change depending on how interest rates change. However, your rate can’t go up indefinitely. Your lender will assign a rate ceiling that determines how high your interest rate can rise.
Fixed-rate mortgages are much simpler and easier to understand. The rate you receive on the day you purchase your property will stay the same until you refinance, sell, or pay off the loan.
Some people prefer fixed-rate mortgages for their dependability, but the low introductory rate offered on an ARM can be appealing. It may be worthwhile to take advantage of the low introductory rate and refinance before it adjusts.
ARMs may also be a good choice for anyone moving into a starter home. You can use the house to build credit and equity, then upgrade to a larger home before the rate adjusts.
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Types Of Fixed-Rate Mortgages
There are many different types of loans that offer fixed rates. Here are the loans you can consider as you’re researching your options:
- Conventional loans: A conventional loan is a home loan that isn’t backed by the federal government. These loans are offered by private mortgage lenders like banks and credit unions.
- Government loans: A government loan is also offered by a private lender, but it’s backed by the federal government. These loans can be more accessible for borrowers with poor credit or lower down payments. FHA loans, VA loans and USDA loans are examples of government loans.
- Conforming loans: A conforming loan is a type of conventional loan. It’s any mortgage that meets the standards of Fannie Mae or Freddie Mac.
- Jumbo loans: A jumbo loan is any loan that exceeds the loan limits set by the Federal Housing Finance Agency (FHFA). The 2023 limits are $726,200 in areas with an average cost of living and $1,089,300 for areas with a high cost of living.
How A Fixed-Rate Mortgage Works
There are two primary components of a fixed-rate mortgage: the loan term and the interest rate. Your loan term is the length of time it takes you to pay off the loan. Most loans have either 15- or 30-year loan terms.
Fixed-rate mortgages are an option for nearly every type of loan. FHA loans, VA loans, conventional and jumbo loans all offer fixed-rate home loans. Plus, most mortgage lenders have a fixed-rate option as their standard loan offer.
Nationally, mortgage rates are determined by fluctuations in the bond market and the Federal Reserve. But the interest rate you receive will be based on additional factors like your credit score, debt-to-income ratio and loan terms.
Fixed-rate mortgages are fully amortizing, meaning all of the interest and principal is paid off over the loan term. These mortgages replaced balloon payment mortgages, which required a large payment at the end of the loan term.
Most fixed-rate mortgages start with more of your payment going to interest than principal. Amortization is the scale telling you the balance between the two. As you pay off your loan, more of your payment will be applied to the principal.
Common Fixed-Rate Terms
The most common types of mortgage terms are 15 years and 30 years, though some lenders offer loan terms as short as 8 years.
How To Calculate Your Fixed-Rate Mortgage Payment
Four main components are used to calculate your mortgage payment: principal, interest, taxes and insurance. The principal is the amount you borrow from your lender to buy the home.
The interest is the fee you pay your lender for them loaning you the money. Your interest will continue to decrease as you pay off your loan. You’ll also pay for homeowners insurance and property taxes. These will be based mainly on the value of your property.
If you want to figure out how much you can expect to pay, be sure to check out this mortgage calculator.
Pros And Cons Of A Fixed-Rate Mortgage
Let’s look at some of the biggest pros and cons of taking out a fixed-rate mortgage.
- You have a consistent interest rate for the life of the loan.
- Having the same monthly payments makes budgeting easier.
- Your loan will fully amortize over its full term.
- You can pay extra on your payment to pay down the principal, pay off the mortgage quicker and save on interest.
- Your interest rate may be higher than the introductory rate of an adjustable-rate mortgage (ARM).
- If market rates decrease lower than your fixed rate, you have to refinance to get the lower rate.
- If you’re planning on selling or refinancing within 5 years, an adjustable-rate mortgage may be better.
The Bottom Line
Fixed-rate mortgages are common. These mortgages have the same interest rate throughout the loan term. If you can lock in a low interest rate, a fixed-rate mortgage can be great for you. But if rates are high, you might be best exploring other options.
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