How a Fixed-Rate Mortgage Works
There are several kinds of mortgage products available on the market. Lenders advertise and offer variable, or adjustable-rate mortgages (ARM), or fixed-rate loans. With variable-rate loans, the interest rate isn't fixed. Instead, rates are adjusted above a certain benchmark. These rates tend to change at certain periods. Fixed-rate mortgages, on the other hand, carry the same interest rate throughout the entire length of the loan.
Most mortgagors who purchase a home for the long term end up locking in an interest rate with a fixed mortgage. They prefer these mortgage products because they're more predictable. In short, borrowers know how much they'll be expected to pay each month so there are no surprises.
Unlike variable and adjustable-rate mortgages, fixed-rate mortgages don't fluctuate with the market. So the interest rate in a fixed-rate mortgage stays the same regardless of where interest rates go—up or down.
The amount of interest borrowers pay with fixed-rate mortgages varies based on how long they're amortized. Mortgagors pay more in interest in the initial stages of repayment. More money is applied toward the principal later on. So someone with a 15-year term will pay less in interest than someone with a 30-year fixed-rate mortgage.
Special Considerations
Most amortized loans come with fixed interest rates, although there are cases where non-amortizing loans have fixed rates, too.
Amortized Loans
Amortized fixed-rate mortgage loans are among the most common types of mortgages offered by lenders. These loans have fixed-rates of interest over the life of the loan and steady installment payments. A fixed-rate amortizing mortgage loan requires a basis amortization schedule to be generated by the lender.
You can easily calculate an amortization schedule with a fixed-rate interest when a loan is issued. That's because the interest rate in a fixed-rate mortgage doesn't change for every installment payment. This allows a lender to create a payment schedule with constant payments over the entire life of the loan.
As the loan matures, the amortization schedule requires the borrower to pay more principal and less interest with each payment. This differs from a variable-rate mortgage where a borrower has to contend with varying loan payment amounts that fluctuate with interest rate movements.
Fixed-Rate Mortgage Definition (investopedia.com)Non-Amortized Loans
Fixed-rate mortgages can also be issued as non-amortizing loans. These are usually referred to as balloon-payment or interest-only loans. Lenders have some flexibility in how they can structure these alternative loans with fixed interest rates.
A common structuring for balloon payment loans is to charge borrowers annual deferred interest. This requires interest to be calculated annually based on the borrower’s annual interest rate. Interest is then deferred and added to a lump sum balloon payment at the end of the loan.
In an interest-only fixed-rate loan, borrowers pay only interest in scheduled payments. These loans typically charge monthly interest based on a fixed-rate. Borrowers make monthly payments of interest with no payment of principal required until a specified date.
Fixed-Rate Mortgages vs. Adjustable-Rate Mortgages (ARMs)
Adjustable-rate mortgages are a fixed- and variable-rate hybrid. These loans are also usually issued as an amortized loan with steady installment payments over the life of the loan. They require a fixed rate of interest in the first few years of the loan followed by variable rate interest after that.
Amortization schedules can be slightly more complex with these loans since rates for a portion of the loan are variable. Thus, investors can expect to have varying payment amounts rather than consistent payments as with a fixed-rate loan.
Adjustable-rate mortgages are generally favored by people who don't mind the unpredictability of rising and falling interest rates. Borrowers who know they'll refinance or won't hold the property for a long period of time also tend to prefer ARMs. Borrowers typically bet on rates to fall in the future. If rates do fall, a borrower’s interest decreases over time.
Advantages and Disadvantages of a Fixed-Rate Mortgage
There are varying risks involved for both borrowers and lenders in fixed-rate mortgage loans. These risks are usually centered around the interest rate environment. When interest rates rise, a fixed-rate mortgage will have a lower risk for a borrower and higher risk for a lender.
Borrowers typically seek to lock in lower rates of interest to save money over time. When rates rise, a borrower maintains a lower payment compared to current market conditions. A lending bank, on the other hand, is not earning as much as it could from the prevailing higher interest rates; foregoing profits from issuing fixed-rate mortgages that could be earning higher interest over time in a variable rate scenario.
In a market with falling interest rates, the opposite is true. Borrowers are paying more on their mortgage than what current market conditions are stipulating. Lenders are making higher profits on their fixed-rate mortgages than they would if they were to issue fixed-rate mortgages in the current environment.
Of course, borrowers can refinance their fixed-rate mortgages at prevailing rates if they are lower, but have to pay significant fees to do so.