How Does Fixed-Rate Mortgage Work?

Not all mortgages are the same when it comes to interest rates: some have fixed rates, while others feature variable rates. In the U.S., fixed-rate mortgages are by far the most common type. However, within this category, there are several variations to consider.

Let’s delve into what fixed-rate mortgages are, how they function, and how they compare to adjustable-rate mortgages.

What is a fixed-rate mortgage?

A fixed-rate mortgage features an interest rate that remains unchanged for the entire duration of the loan. This type of mortgage is favored for its stability, as your monthly payment for principal and interest stays consistent. While additional costs like homeowners insurance and property taxes might cause slight variations in your total monthly payment, the core loan payment remains steady, making budgeting and financial planning easier.

Although 30-year terms are the most common, fixed-rate mortgages are also available in 20-year, 15-year, and 10-year options. Many lenders even provide more flexible terms, ranging from eight to 40 years.

How fixed-rate mortgages work

Mortgage rates fluctuate constantly due to various factors, so you might encounter an interest rate of 7.5 percent today and 7.75 percent tomorrow. However, with a fixed-rate mortgage, once you lock in your rate and close on your home, you are shielded from these fluctuations. Your rate remains constant regardless of market changes after your loan is secured.

Although your monthly payment amount stays the same with a fixed-rate mortgage, the allocation of your payment between principal and interest changes over time, following the loan’s amortization schedule. Initially, a larger portion of your payment goes toward interest, while a smaller portion reduces the principal. Over time, this shifts, and more of your payment goes toward the principal.

For example, if you make a 20 percent down payment on a $375,000 home and take out a $300,000 30-year fixed-rate mortgage at 7.5 percent interest, your monthly payment (excluding insurance and taxes) would be $2,097 for the full term. In the first month, approximately $220 of your payment would reduce the principal, while the remainder covers interest. After 20 years, nearly half of your payment, or $984, would be applied to the principal. By the end of the term, interest will make up less than half of your payment. This gradual shift is how you build home equity and eventually own the property outright.

Pros and cons of a fixed-rate mortgage

Opting for a fixed-rate mortgage for your new home has both advantages and disadvantages to consider.

Pros of a fixed-rate mortgage

• Stable Payments: While your homeowners insurance and property taxes might vary, your mortgage payments will remain consistent, making it easier to manage your budget each month.
• Fixed Interest Rate: Your interest rate is locked in for the entire term of the loan, regardless of fluctuations in the market.

Cons of a fixed-rate mortgage

• Higher Interest Rates: Lenders typically charge more for fixed-rate mortgages because they limit their potential gains when interest rates rise. As a result, monthly payments are often higher compared to adjustable-rate mortgages, especially at the outset.
• No Immediate Rate Reduction: If market interest rates decrease, you won’t benefit from the lower rates. The only way to adjust your fixed rate downward is through refinancing, which involves time and additional costs.

Types of fixed-rate mortgages

Before exploring your mortgage options, it’s important to understand the different types available:

Conventional: Conventional fixed-rate mortgages typically have stricter requirements, such as a minimum credit score of 620 and a debt-to-income ratio no higher than 43 percent, although exceptions may apply. These loans are provided by banks, credit unions, online lenders, savings and loan associations, and mortgage companies.

Government-Backed: FHA, VA, and USDA loans are insured or guaranteed by federal agencies, which protect lenders if the borrower defaults. FHA loans are available to borrowers with lower credit scores, USDA loans are intended for specific borrowers in rural areas, and VA loans are for military service members, veterans, and eligible family members.

Conforming: Conforming loans meet Federal Housing Finance Agency (FHFA) requirements, including loan limits, allowing them to be sold on the secondary market. This adherence helps maintain liquidity in the mortgage market.

Non-Conforming: Non-conforming loans, such as jumbo loans, do not meet FHFA standards. As a result, they may come with higher interest rates and stricter requirements regarding credit score and cash reserves.

Amortizing: Most fixed-rate mortgages are amortizing loans, meaning that each monthly payment contributes to both principal and interest. While the total payment amount remains the same throughout the loan term, the portion applied to principal versus interest changes over time, ensuring the loan is fully paid off by the end of the term.

Non-Amortizing: Less common, non-amortizing loans offer lower monthly payments that may cover only the interest for a certain period. At the end of this period, a balloon payment— a large lump sum covering all or most of the principal—is typically required.

Fixed-rate mortgage term options

You’ll repay your fixed-rate mortgage over a specified term.

30-Year Fixed-Rate Mortgage: This is the most common term, allowing you to spread your loan payments over 30 years. While it may seem lengthy, this extended period lowers your monthly payments, providing more flexibility in your budget.

15-Year Fixed-Rate Mortgage: A 15-year term usually offers a lower interest rate compared to a 30-year mortgage. However, you’ll need to repay the loan in half the time. This option is ideal for borrowers with strong cash flow who want to pay off their homes more quickly and reduce overall interest payments.

Other Fixed-Rate Mortgage Terms: Many lenders offer customized terms, ranging from eight to 30 years, to better fit your financial situation.

Although the term of your mortgage determines the maximum repayment period, you can opt to make additional payments toward the principal to shorten the loan term. Ensure your loan doesn’t have a prepayment penalty (most do not) and that any extra payments are applied directly to reducing the principal.

Fixed-rate mortgage example

Meet Jill, a first-time homebuyer transitioning from renting. After careful budgeting, Jill has determined she can comfortably handle a mortgage payment of about $1,200 per month, covering principal and interest.

By working backward from this monthly budget, we can estimate the loan amounts Jill could potentially borrow with two different fixed-rate mortgages. (Note: This example does not account for down payments or closing costs.)

Loan Amounts and Terms:

With a 30-year fixed-rate mortgage, Jill can borrow $35,000 more for approximately the same monthly payment compared to a 15-year fixed-rate mortgage.

If Jill’s budget and excellent credit allow her to choose the $175,000 loan, opting for a 30-year fixed-rate mortgage offers the benefit of lower monthly payments but comes with a higher interest rate and a larger total cost in terms of interest:

Total Interest Costs:

If Jill can manage the higher monthly payments of a 15-year mortgage, she would save over $181,000 in interest. However, if these payments are too high, the 30-year mortgage might be a more manageable option despite the increased total interest cost.

Fixed-rate mortgages vs. adjustable-rate mortgages

While fixed-rate mortgages are the most popular choice among Americans, they aren’t the only option available. Adjustable-rate mortgages (ARMs) offer a different approach, with interest rates that fluctuate based on current market conditions. When deciding between adjustable-rate and fixed-rate loans, there are several important factors to consider.

Interest rates

With a fixed-rate mortgage, the interest rate remains constant throughout the life of the loan. On the other hand, many adjustable-rate mortgages (ARMs) begin with a fixed interest rate for an initial period, after which the rate adjusts periodically—typically every year or six months—based on a designated interest-rate index.

ARMs usually have rate caps to limit how much the interest rate can increase. These caps prevent the rate from rising too quickly either at each adjustment period or over the entire term of the loan. For instance, if you start with an ARM at 7 percent, the cap might restrict the maximum interest rate to 12 percent over the loan’s duration.

Risks

ARMs carry more risk compared to fixed-rate mortgages. The fluctuating interest rates can lead to unpredictable payments, unlike fixed-rate mortgages where the payment amount remains stable. If your ARM rate increases, you’ll pay more in interest over the life of the loan.

Length of the time in the home

ARMs are often better suited for borrowers who expect to move within a few years, ideally while the loan is still in its initial fixed-rate phase. If you plan to stay in your home for a long, indefinite period, a fixed-rate mortgage might be a more stable option.

To illustrate the differences between a fixed-rate mortgage and an ARM, let’s revisit our example of Jill:

Assume Jill chose a 15-year fixed-rate mortgage for $140,000 at 6.82 percent. Over the life of this loan, she would pay a total of $83,976 in interest. We can now look at the amortization table to understand her total payments.

Let’s consider if Jill opted for a 5/1 ARM instead, with an initial five-year fixed rate of 6.83 percent on the same $140,000 loan. Assuming a yearly adjustment of at least 0.25 percent and an interest rate cap of 12 percent, she might end up paying around $90,834 in total interest over the 15-year term. However, because the rate can fluctuate annually after the initial five-year period, the actual interest paid could vary. Here’s an amortization table that outlines her potential total payments:

Should you get a fixed-rate mortgage?

A fixed-rate mortgage is a solid option for many homebuyers, offering the benefit of consistent monthly payments and stable interest rates throughout the life of the loan. This makes it a great choice for those who plan to stay in their home for an extended period.

However, while fixed-rate mortgages are popular in the U.S., they may not be ideal for everyone. The primary drawback is the higher interest costs, especially in the early years of the loan. You’re committed to a set rate for the duration of the loan, and if interest rates fall, refinancing is the only way to lower your rate. For those who don’t plan on staying in their home long-term, adjustable-rate mortgages (ARMs) with their initial lower rates might be a more advantageous option.