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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The overwhelming majority of home buyers and homeowners choose fixed-rate mortgages over their counterparts, adjustable rate mortgages (ARM). And with current interest rates hovering near all-time lows, there’s almost no reason for the average homebuyer to consider an ARM.

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 mortgage 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. 

How a Fixed-Rate Mortgage Works

A fixed-rate mortgage is a home with an interest rate that never changes for the duration of the loan’s repayment term. This means that the mortgage and interest you pay each month will always be the same.

However, your monthly housing expenses can still change. 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.

What Is a Fixed-Rate Mortgage?

Fixed-rate mortgages are available with a variety of term lengths. The most common options are 15- and 30-year terms. Typically, the mortgage 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. 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.

Amortized vs. Non-Amortized Loans

An amortized loan is a type of loan with regular set payments over a specified period of time. For example, a 20-year mortgage would have a 20-year amortization schedule, and at the end of the 20 years would be fully paid off. The vast majority of loans used by buyers looking from a primary residence are fully amortizing loans.

A non-amortized loan has a payment schedule that won’t result in the full loan balance being paid off at the end of the repayment term. These loans typically require a lump sum payment (i.e. balloon payment) to pay off the loan balance. A home equity line of credit (HELOC) is a popular type of non-amortized loan.

Pros and Cons of a Fixed-Rate Mortgage

Fixed-rate mortgages are extremely popular, and the predictability makes sense for more homebuyers. But there are trade offs to consider in certain limited situations.

Pros

  • Monthly principal and interest payments never change

  • Lower monthly payments on longer-term 30-year mortgages

  • You never need to worry about interest rates increasing

  • Can afford to pay more for a house (with a 30-year loan)

Cons

  • May have a higher interest rate

  • More interest paid over the life of the loan (for 30-year mortgages)

  • Could cost more during the first 5 years compared to a 5/1 ARM

  • Slower equity growth for longer-term loans

Fixed-Rate Mortgages vs. Adjustable-Rate Mortgages

When deciding on whether an ARM or fixed-rate loan makes sense, you should look at the numbers and your personal situation. How long you plan on staying in the home can be as important as the rate difference between the two loans.

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 an all-time record low in January 2021 and while they’re slightly higher now, 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, there isn’t much room for it to drop.

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 you pay average 3%-6% of the loan amount.

On a $300,000 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 larger. 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 enough homes or wouldn’t be able to secure a low enough introductory rate with an ARM, which is likely one reason why 90% opt for a 30-year fixed-rate mortgage.