What is a fixed-rate mortgage and how does it work?

Not all mortgages are created equal. While some borrowers choose adjustable-rate mortgages (ARMs), by far the most common loan type is the fixed-rate mortgage. Yet even with fixed-rate loans, there is a variety of options.

What is a fixed-rate mortgage?

A fixed-rate mortgage has an interest rate that remains the same for the life of the loan. Fixed-rate loans are the most popular type of financing because they offer predictability and stability. You’ll never be surprised by the principal and interest charges in your monthly mortgage payment, because they’ll stay the same for the entire loan term. (Your total monthly payment, which includes homeowners insurance and property taxes, might have small fluctuations due to changes in those costs.)

The most common type of fixed-rate mortgage is a 30-year loan, but you’ll see offerings for 20-year, 15-year and 10-year loans, too. Many lenders also offer flexible terms between eight years and 30 years.

How fixed-rate mortgages work

The rates mortgage lenders advertise are always moving up and down due to several factors. So, you might see an offer for a 7.5 percent interest rate today and a 7.75 percent interest rate tomorrow. With a fixed-rate mortgage, once you lock in your rate, that movement doesn’t impact you. No matter what happens after you secure your loan, the rate you locked in remains the same.

This differs from ARM loans. With these types of home loans, the lender can adjust the interest rate either up or down depending on market conditions.

With a fixed-rate mortgage, your payment amount also stays the same, but the breakdown of where those funds go — how much is paying down the principal versus how much is paying interest charges — varies based on the amortization schedule.

Let’s say you make a 20 percent down payment on a home with a purchase price of $375,000, and you borrow $300,000 with a 30-year fixed-rate mortgage at 7.5 percent interest. You’d have a $2,097 payment each month toward principal and interest, excluding insurance and taxes, for the next 30 years.

In the first month of your term, only about $220 of your payment would go toward the actual principal, with the remainder going toward interest. Twenty years later, nearly $1,000 of your payment would be going toward the principal. As the balance of those payments tilts more toward your principal, you’re accelerating the equity you have in the property.

Pros and cons of a fixed-rate mortgage

There are several benefits to choosing a fixed-rate mortgage to purchase a new home. There are also disadvantages worth considering before deciding if this type of mortgage is right for you.

Pros of a fixed-rate mortgage

• Predictable mortgage payments: Though your homeowners insurance and property tax payments might fluctuate, your mortgage payments will stay exactly the same. This is no small benefit when it comes to budgeting your monthly spending and managing your financial health.
• Fixed interest rate: Your interest rate will also stay exactly the same. Regardless of how rates rise or fall over time, you’ll maintain the rate you locked in when you acquired the loan.

Cons of a fixed-rate mortgage

• Higher interest rates than adjustable loans: Because lenders lose the flexibility to earn more if interest rates go up, they charge more for a fixed-rate mortgage compared to the introductory rate on an ARM. As a result, the monthly payments for fixed-rate loans will be higher (at least initially) than those of ARM mortgages.
• No easy way to reduce your rate: If rates fall, you won’t benefit. The only way to reduce your fixed rate is to refinance, which involves time and expenses.

Fixed-rate mortgage term options

You’ll pay back your fixed-rate mortgage over a predetermined term. The most common offering is a 30-year fixed-rate mortgage, which allows you to pay off your home loan over three decades. That might sound like a long time, but the extended timeline reduces the size of your monthly payment to free up room in your budget.

Another widely available option is a 15-year fixed-rate mortgage. This typically comes with a lower interest rate, but you’ll need to pay back the loan in half the time. A 15-year fixed-rate mortgage is ideal for borrowers who have the cash flow and want to pay off their home faster with less interest.

Some mortgage lenders let you customize the term, too, between eight years and 30 years.

While the term attached to a fixed-rate mortgage is the maximum amount of time you have to repay it, you can also opt to contribute additional money toward the principal to shorten your pay-back period. Just make sure your loan doesn’t have a prepayment penalty (most don’t), and that the extra payments are paying down the principal. You can contact your lender to confirm this.

Types of fixed-rate mortgages

There are also different types of fixed-rate mortgages to be aware of before exploring your options:

• Conventional – Conventional fixed-rate mortgages typically come with slightly stricter requirements, such as a minimum 620 credit score and a debt-to-income (DTI) ratio no higher than 43 percent, although there are exceptions to these rules. These loans are issued by banks, credit unions, online lenders and other types of lending institutions.
• FHA, VA, USDA – In some respects, FHA loans, VA loans and USDA loans are easier to qualify for than conventional loans. FHA loans are the most widely available, while USDA loans are designated for certain borrowers in rural areas. VA loans are reserved for military service members, veterans and eligible family members.
• Conforming – A conforming loan adheres (“conforms”) to requirements from the Federal Housing Finance Agency (FHFA), such as loan limit, that allow it to be sold on the secondary market. As long as a loan meets these standards, it can be bought and sold to help keep money flowing through the mortgage market.
• Non-conforming – Non-conforming loans, including jumbo loans, don’t meet some FHFA requirements. To qualify, you might pay a higher rate and need to check off some stricter requirements in terms of your credit score and cash reserves.
• Amortizing – The vast majority of fixed-rate mortgages are amortizing loans, which means that your monthly payments go toward both the principal and the interest charges. From the first day you start paying an amortizing loan back, you’re building equity in the home.
• Non-amortizing – Non-amortizing loans are much less common, but come with an appealing benefit: significantly lower monthly payments that might only cover the interest for a period of time. When that benefit expires, though, you could be in for a rude awakening with a balloon payment.

How to calculate fixed-rate mortgage costs

Calculating your fixed-rate mortgage payment involves a bit of math. You can use Bankrate’s mortgage calculator to get a sense of how much you’ll pay each month.

As you come up with a ballpark for how much house you can afford, remember to consider the additional costs of owning a home, such as property taxes, homeowners insurance, HOA fees and maintenance and repairs.

Example of a fixed-rate mortgage

Meet Jill, a first-time homebuyer who wants to stop renting. She’s crunched the numbers and knows she can afford around $1,200 per month for mortgage principal and interest costs.

Working backward from that monthly payment, we can get a sense of how much Jill might be able to borrow between two different fixed-rate mortgages. (Note: We did not assume a down payment or closing costs in this scenario.)

For about the same monthly payment, Jill can borrow $35,000 more with a 30-year fixed loan compared to a 15-year loan.

Now, let’s say Jill’s budget and solid credit allows her to opt for the $175,000 loan, regardless of loan term. If she chooses a 30-year fixed-rate mortgage, she’ll pay a higher interest rate but enjoy the ability to stretch out the payback period. That convenience of a longer term comes with a major drawback, though: a much bigger price tag for overall interest charges:

If Jill can afford the higher monthly payments of a 15-year mortgage, she’ll save over $181,000 in interest.

Fixed-rate mortgages vs. adjustable-rate mortgages

As you compare fixed-rate mortgages, you might also come across adjustable-rate mortgages (ARMs). True to its name, the rate on an ARM adjusts as the market changes, but the loan comes with an introductory rate for a period of time.

For example, a 5/6 ARM has a five-year introductory rate. After that five-year time frame, your rate will change once every six months. How the rate moves (up or down) depends on the index to which it’s tied. The rate increases might be capped at 2 percent annually, say, and 5 percent for the life of the loan.

ARMs are more complex loans, and they’re generally more beneficial for a borrower who doesn’t plan to live in the home for a long time.