What is a fixed-rate mortgage?

January 14, 2013, 04:59:00 PM EDT


When you're looking to borrow $100,000 to buy a house, or maybe even more, many people understandably want some predictability when it comes to paying their bills. For those looking for consistency first and foremost, the best option is a fixed-rate mortgage loan.

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In the earlier days of home financing, many loans followed the "balloon payment" formula, which would force borrowers to pay off the full remainder of a loan after a fixed period, which meant greater risks and more defaults. That pattern only changed through the efforts of the federal government, which actively encouraged the use of long-term fixed-rate mortgages.

This type of financing charges a single interest rate over the course of a long repayment period, usually either 30 or 15 years. For many years, the 30-year fixed-rate mortgage was the standard housing loan, but now some lenders will also consider loans for 10, 20 or 25 years, though it is far less common. A larger part of the market has instead moved toward the adjustable-rate mortgage, which changes its interest rate from year to year.

What are the advantages and disadvantages?
Adjustable-rate mortgages have been on the rise in the past few decades primarily because they are easier to tailor and adjust to specific circumstances, while fixed-rate mortgages are often somewhat interchangeable. Part of that fact is that fixed-rate mortgages are treated as financial products, often being traded between banks like other kinds of assets.

But, while fixed-rate mortgages are somewhat standardized, for borrowers this has advantage of giving a pretty clear picture of costs and benefits for these types of loans.

The biggest and most important disadvantage for fixed-rate mortgages, at least certainly for the 30-year loans that represent most of the market, is the cost. Because of their long lives, fixed-rate mortgages incur significantly more interest than most other loans, and the longer loans generally incur higher interest rates to begin with.

This added cost can be turned to a borrower's advantage in certain instances, however, as mortgage interest payments can be written off federal taxes, and the offset taxes from the larger interest costs can prove valuable in the long run.

Meanwhile, many borrowers see the predictability of monthly payments as an important advantage for fixed-rate mortgages, as these bills will not change throughout the course of the loan short of refinancing. If you can secure a fixed-rate loan during a period of low interest rates, you can ensure lower payments than you are likely to see with adjustable-rate mortgages.

That said, if interest rates are high, fixed-rate mortgages are likely to incur unnecessarily high costs and, if rates drop in the future, it can cost thousands of dollars in fees to refinance the loan.

Probably the biggest decision with a fixed-rate mortgage, however, is simply whether you want to go for the standard length or search for a 15-year loan.

If you can afford to make the higher monthly payments, then 15-year mortgages will allow you to build equity (or ownership) in your home faster by paying down the principal loan amount faster. The standard 30-year mortgage will primarily be paying off interest for the greater part of the loan, only eating significantly into the principal in the latter half.

By the same token, however, if you can afford to pay higher costs you could also just as easily purchase a larger or more expensive home with a longer mortgage.