Fixed-Rate Mortgage

How Does a Fixed-Rate Mortgage Work?

A fixed-rate mortgage is a loan where the charged interest rate remains constant over the entire borrowing term.

In real estate lending, a fixed-rate mortgage is a form of financing in which the interest rate is consistent over the borrowing term.

Since the interest rate remains unchanged over the term of the borrowing, there is far more consistency in the payments owed to the lender as part of the financing arrangement.

The borrowing term on a fixed-rate mortgage most often consists of 15, 20, and 30-year maturities.

The interest rate on a loan, or the cost of borrowing, is priced by lenders to reflect the riskiness of providing capital to a particular borrower.

From the perspective of a lender, the higher the perceived credit risk and the chance of the borrower defaulting on the loan, the higher the interest rate is set (and vice versa).

The monthly payment owed to the lender consists of the principal amortization and interest expense. The relationship between the principal and interest payment is that interest is charged on the outstanding principal of the loan.

Over the borrowing term, the proportion of principal in the total payment to the lender increases while the interest decreases. However, to reiterate, the interest rate charged on the loan remains fixed.

In the lending agreement, which states the contractual terms of the borrowing, the structure of the interest rate is most often either on a floating or fixed basis.

• Floating Interest Rate → The interest rate pricing is variable and fluctuates based on changes in an underlying index (e.g., SOFR).
• Fixed Interest Rate → The interest rate, as implied by the name, remains constant, irrespective of changes in the economic conditions and other external factors.

Therefore, the differentiating feature of a fixed-rate mortgage is the constant interest rate over the borrowing term, which offers more predictability in the monthly payment obligations for the borrower.

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Fixed-Rate Mortgage: What are the Pros and Cons?

The primary benefit of a fixed-rate mortgage is the predictability factor since the monthly interest and principal payments owed on a loan are consistent over the borrowing term.

Because the interest obligation is not tied to any underlying index, there is more stability attributable to the borrowing (i.e., no unexpected fluctuations in the monthly payments).

Therefore, the process of planning for the borrower is much easier because the interest expense burden and principal payments are pre-determined on the date of original issuance.

For instance, fixed-rate mortgages offer borrowers protection from the market interest rate rising.

On the other hand, the drawback to fixed-rate mortgages is that lenders tend to charge higher interest rates relative to other forms of financing.

Why? If the market interest rate were to rise, a lender would earn more on a loan priced at a floating interest rate.

But for a fixed-rate mortgage, the lender does not receive more interest (and a higher yield) in such market conditions.

1. Rising Market Interest Rate → The borrower benefits since the interest rate on the loan is lower than the current market rate.
2. Falling Market Interest Rate → The lender benefits because the interest rate on the loan is lower than the current market rate.

Furthermore, the initial monthly payments on fixed-rate mortgages tend to be higher in comparison to mortgages with variable pricing since interest is charged based on the outstanding principal balance.