Fixed-rate Mortgages: What Are They and How Do They Work?

Photo to accompany story about choosing a fixed-rate mortgage. Getty Images

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Borrowers are flocking to fixed-rate mortgages.

According to the most recent data from Ellie Mae, fixed-rate home loans accounted for 97% of all mortgage loan volume originated in July 2020. That includes both home purchases and refinances.

Fixed-rate loans have historically been more popular than their counterparts, adjustable rate mortgages (ARM). But with interest rates hovering near all-time lows, there’s almost no reason for the average homebuyer to consider an ARM in 2020.

That’s because with rates so low, the risk of an adjustable rate mortgage—which can become more expensive as rates rise—just isn’t worth it, says Walda Yon, chief housing programs officer at the Latino Economic Development Center. So if you’re able to qualify for the best rates, a fixed-rate mortgage is going to be the most stable and affordable option.

Before you sign the dotted line on a new fixed-rate home loan, here’s what you need to know. 

What Is a Fixed-Rate Mortgage?

A fixed-rate mortgage has an interest rate that never changes. This means your mortgage and interest payments stay the same over the life of the loan. Your overall mortgage payment could still increase or decrease if your property taxes or homeowners insurance change, says Yon, but it typically won’t be an excessive increase.

Fixed-rate mortgages are available with a variety of term lengths. The most common options are 15- and 30-year terms. Typically, the interest rate is higher on longer-term loans. So, all else being equal, a 15-year mortgage will have a lower rate than a 30-year loan. But shorter loans have bigger monthly payments, so it’s a tradeoff. 

Most people want a 30-year fixed-rate loan, says Scott Lindner, the national sales director for mortgage lending at TD Bank. But if you’re retiring in 15 years, for example, a shorter loan you can pay off quicker could be better, he says. A lower interest rate and shorter term also means you’ll pay less in interest over the course of the loan. 

As an example, let’s look at a $200,000 home purchased with 10% down. Here’s how much it would cost each month and over the life of the loan for a 30-year mortgage and a 15-year mortgage.

Mortgage TermLoan AmountInterest rateMonthly Mortgage & Interest PaymentTotal Cost of the Loan Over the Full Term
30 years$180,0003%$758$273,396
15 years$180,0002.5%$1,200$216,048

You’ll pay nearly $500 a month more for a 15-year mortgage, but save almost $50,000 over the life of the loan. And that’s with the same interest rate; keep in mind that a 15-year loan will almost certainly have a lower interest rate than a comparable 30-year mortgage. But, as you can see, the length of the loan can have a much bigger effect on the overall cost than the interest rate.

Pro Tip

With a fixed-rate loan, your mortgage and interest payments will never increase, but your monthly payments could change if your homeowners insurance or property taxes go up.

Why Now Is the Right Time for a Fixed-Rate Home Loan

Simply put, now is one of the best times ever to get a fixed-rate mortgage. Rates dipped to a new record low in August and while they’ve gone up slightly since then, they are still near rock bottom. 

On the other hand, an ARM has a rate that will change with the market over the life of the loan. And when you start with a rate that’s at rock bottom, it can only go up from there.

Locking in an all-time low mortgage rate has another huge advantage on top of saving on interest payments – you’re less likely to need to refinance for a better rate in the future. Refinancing can save borrowers five figures in interest over the life of the loan. But it’s not free, and the closing costs that must be paid average 3%-6% of the loan amount.

On a $200,000 refinance, that’s a cool $10,000 or more in fees. Also, if you refinance to a longer-term loan, you’re extending the amount of time you’ll be stuck paying a mortgage. If you replace a loan with only 20 years left with a new 30-year mortgage, you just added another decade of mortgage payments

If you lock in great rates now, refinancing is an expense you can avoid down the road.

When an ARM Might Make Sense

Mortgage rates need to be higher before an adjustable rate mortgage makes sense. Specifically, the difference between an ARM and fixed mortgage rate, known as the spread, should be bigger. 

In today’s rate environment 15-year or 30-year fixed-rate loans are relatively close in rates to an ARM’s introductory APR, Lindner says. So there’s not a huge benefit to an ARM.

Even then, ARMs only make sense in very specific circumstances.

If you’ll be selling your home  before an adjustable rate changes, then the lower introductory rate and monthly payments of an ARM can be cheaper than a fixed-rate mortgage. If you know you’re going to have a huge increase in salary in the next few years, an ARM can make sense, Yon says. But for most borrowers a fixed-rate loan is a better option for creating long term wealth, she emphasized. 

An ARM’s savings are increased the bigger the loan gets. For a $600,000 ARM with a teaser rate that’s 1% lower than what you’d get with a fixed-rate loan (from 4% to 3%), you could save $30,000 over five years. But if the loan amount is for $200,000, the savings drops to around $10,000 over the same time period. The majority of buyers aren’t in the market for expensive homes, which is likely one reason why 90% opt for a 30-year fixed-rate mortgage.