When shopping for a home mortgage, there are a dizzying array of options available to you. The most popular option is the fixed-rate mortgage, which offers an interest rate that does not fluctuate for the entire length of the mortgage.
With a fixed-rate mortgage, the homeowner can make the same payment each month until the mortgage is paid off. However, that predictability can come with higher closing costs, and the traditional 30-year fixed-rate mortgage is one of the toughest mortgages to get approved for. While there are certainly disadvantages, getting a fixed-rate mortgage can make sense for some buyers.
Understanding Fixed-Rate Mortgages
Length of the Fixed Rate
When most people think of a fixed-rate mortgage, they imagine a mortgage in which the rate is the same every day for the duration of the mortgage. One trick that has been used on many unsuspecting home buyers in the last several years is for a broker to say that a mortgage is a 30-year fixed-rate mortgage when, in actuality, it is a 30-year mortgage in which the rate is fixed only for a few years.
If you are shopping for a fixed-rate mortgage and are offered a deal that’s a little too good to be true, be sure to clarify the length of time the rate will remain fixed. If the rate is fixed for 5 years, but the mortgage is for 30, you may not have any idea what your payments will be when the fixed-rate period expires.
Determining Your Interest Rate
Many factors are considered when determining your interest rate on a fixed mortgage, including:
- Current Prevailing Interest Rates. Unlike an adjustable-rate mortgage (ARM), where the interest rate can change periodically, the rate on a true fixed-rate mortgage will remain the same permanently. The rate that you get is based on the prevailing interest rates available at the time you sign your paperwork.
- Your Personal Financial Situation. Your credit score, the amount of your down payment, and the size of the mortgage you want to obtain all contribute to determining your rate. Keep this in mind when perusing average mortgage rates on a site such as Bankrate, as these do not reflect your personal situation.
- Who Pays Closing Costs. Another way that your interest rate can be affected is whether you choose to roll certain costs into the interest rate. For example, you may be willing to accept a slightly higher interest rate in order to have the bank cover your closing costs. In fact, this is fairly common – you may have also heard it referred to as a “no-cost loan.”
- Private Mortgage Insurance. A second way that a higher rate can benefit you is if you choose to use lender-paid mortgage insurance instead of getting private mortgage insurance (PMI). Here again, instead of paying an amount out-of-pocket, the bank pays the cost to insure your loan in return for your acceptance of a higher rate.
Cost Tradeoff of a Predictable Payment
While the fixed-rate mortgage is the most popular mortgage option, it is also generally the most expensive in terms of what you must pay up front. With an adjustable-rate mortgage, the bank makes more money when interest rates go up, but with a fixed-rate mortgage, the bank makes a 30-year bet. If interest rates go up after you have your mortgage in place, the bank loses potential profit, but it’s certainly better for your wallet. That potential loss in profit is why there is usually a big upfront cost difference between a fixed-rate mortgage and an adjustable-rate mortgage.
After living in their home a few years and writing the same check every month, many people with fixed-rate mortgages are shocked to receive a bill that’s higher than what they’re used to paying. This scenario commonly occurs when homeowners have their property taxes and home insurance paid for out of escrow. If you have an escrow account, your monthly payment includes a portion for taxes and insurance in addition to the mortgage payment. The excess amount is then directed to the escrow account. When your home insurance premiums and property taxes come due, the mortgage company will administer these payments out of the escrow account.
However, if your taxes or insurance costs go up, your mortgage servicer will bump up your monthly payment to cover the increase – even though your actual mortgage payment won’t change.
While it is the most popular option, a fixed-rate mortgage may be better for some homeowners than for others. In general, while rates are low, a fixed-rate mortgage is best for those who plan to stay in the same home for several years, or are refinancing and plan to continue to live in the home.
You may not benefit from a fixed-rate mortgage if any of the following scenarios apply to your situation:
- If prevailing rates are currently high, you probably should not lock in at that high rate.
- If you don’t plan to stay in the home for more than a few years, the upfront cost of a fixed-rate mortgage might make it less cost-effective.
- If you don’t have good credit, you may not be able to qualify for a favorable rate, or you may not be able to qualify at all.
- If you aren’t currently able to make the high payments of a fixed-rate mortgage, but will have additional income soon (e.g., if you are completing a medical residency), a hybrid ARM might be easier to qualify for.
Having a fixed-rate mortgage offers many benefits:
- Payment Predictability. Your mortgage payment will remain the same – even though payment fluctuation to your servicer may change.
- Ease of Paying Down Principal. Most fixed-rate mortgages do not come with overly restrictive prepayment penalties, so you’re more able to make extra payments towards principal without fees.
- Stable Interest Rates. If the mortgage market significantly worsens, you don’t have to worry about paying more in interest. And if it gets better, you can refinance to get the better rate.
Despite the benefits, an alternative mortgage may be more suitable, depending on your situation. There are several disadvantages that may make you decide that the fixed-rate mortgage is not for you:
- Expensive Up-Front Costs. Closing costs, such as origination fees, discount points, and underwriting fees, are often higher than with other types of loans.
- Higher Comparable Interest Rate. If you aren’t planning to be in the home for a long period of time, you can likely get a better interest rate for the time you will be there by choosing a hybrid ARM.
- Difficult to Qualify For. Because the payment is higher and the closing costs greater, those with poor credit or who plan to make a smaller down payment may have difficulty getting a good deal, or getting a deal at all.
While the 30-year fixed-rate mortgage remains the most popular loan available, that predictability costs more upfront than an adjustable-rate loan. And with the increasing mobility of American families, many people don’t stay in their homes long enough to truly benefit from the advantages of a fixed-rate mortgage. Thoroughly assess your situation to determine what type of loan is right for you, and contact multiple lenders before signing any documents.
What factors are important to you when deciding what type of mortgage to get?