Fixed-Rate Mortgage: How It Works, Types, vs. Adjustable Rate

What Is a Fixed-Rate Mortgage?

The term fixed-rate mortgage refers to a home loan that has a fixed interest rate for the entire term of the loan. This means that the mortgage carries a constant interest rate from beginning to end. Fixed-rate mortgages are popular products for consumers who want to know how much they have to pay every month. Fixed-rate mortgages may be open or closed with specific terms of 15 or 30 years or they may run for a length of time agreed upon by the lender and borrower.

How a Fixed-Rate Mortgage Works

Several kinds of mortgage products are available on the market, but they boil down to two basic categories: variable-rate loans and fixed-rate loans. With variable-rate loans, the interest rate is set above a certain benchmark. It then fluctuates, which means it changes at certain periods.

Fixed-rate mortgages carry the same interest rate throughout the entire length of the loan. Unlike variable- and adjustable-rate mortgages, fixed-rate mortgages don’t fluctuate with the market. So the interest rate in a fixed-rate mortgage stays the same regardless of where interest rates go—up or down.

Most mortgagors who purchase a home for the long term end up locking in an interest rate with a fixed-rate mortgage. They prefer these mortgage products because they’re more predictable. In short, borrowers know how much they’ll be expected to pay each month, so there are no surprises.

The mortgage term is basically the life span of the loan—that is, how long you have to make payments on it. In the United States, terms can range anywhere from 10 to 30 years for fixed-rate mortgages; 10, 15, 20, and 30 years are the usual increments. Of all the term options, the most popular is 30 years, followed by 15 years.

How to Calculate Fixed-Rate Mortgage Costs

The actual amount of interest that borrowers pay with fixed-rate mortgages varies based on how long the loan is amortized. That is the period for which the payments are spread out. While the interest rate on the mortgage and the amounts of the monthly payments themselves don’t change, the way that your money is applied does. Mortgagors pay more toward interest in the initial stages of repayment; later on, their payments are going more into the loan principal.

So, the mortgage term comes into play when calculating mortgage costs. The basic rule of thumb: The longer the term, the more interest that you pay. Someone with a 15-year term, for example, will pay less in interest than someone with a 30-year fixed-rate mortgage.

Crunching the numbers can be a bit complicated: To determine exactly what a particular fixed-rate mortgage costs—or to compare two different mortgages—it’s simplest to use a mortgage calculator.

You plug in a few details—typically, home price, down payment, loan terms, and interest rate—push the button, and get your monthly payments. Some calculators break those down, showing what goes to interest, principal, and even (if you so designate) property taxes. They’ll also show you an overall amortization schedule, which illustrates how those amounts change over time.

For the Math-Minded

If you’re into crunching numbers, there’s a standard formula to calculate your monthly mortgage payment by hand.

$\begin{aligned}&M=\frac{P|i(1+i)^n|}{[(1+i)^n-1]}\\&\textbf{where:}\\&M=\text{Monthly payment}\\&P=\text{Principal loan amount (the amount that you borrow)}\\&i=\text{Monthly interest rate}\\&n=\text{Number of months required to repay the loan}\end{aligned}$​M=[(1+i)n−1]P∣i(1+i)n∣​where:M=Monthly paymentP=Principal loan amount (the amount that you borrow)i=Monthly interest raten=Number of months required to repay the loan​

​So, to solve for the monthly mortgage payment (M), you plug in the principal (P), the monthly interest rate (i), and the number of months (n).

If you want to calculate the mortgage interest alone, here’s a fast formula for that:

$\begin{aligned}\text{monthly interest}=\frac{(\text{loan balance}\times\text{interest rate})}{12}\end{aligned}$monthly interest=12(loan balance×interest rate)​​

Fixed-Rate Mortgages vs. Adjustable-Rate Mortgages (ARMs)

Adjustable-rate mortgages (ARMs) are something of a hybrid between fixed- and variable-rate loans. They have both fixed- and variable-rate components and are also usually issued as amortized loans with steady installment payments over the life of the loan. They require a fixed rate of interest in the first few years of the loan, followed by variable-rate interest after that.

Amortization schedules can be slightly more complex since rates for a portion of these loans are variable. Thus, investors can expect to have varying payment amounts rather than consistent payments as with a fixed-rate loan.

People who don’t mind the unpredictability of rising and falling interest rates may favor ARMs. Borrowers who know that they either will refinance or won’t hold the property for a long period of time also tend to prefer ARMs. These borrowers typically bet on rates to fall in the future. If rates do fall, then a borrower’s interest decreases over time.

Fixed-Rate Amortized vs. Non-Amortized Mortgages

Most amortized loans come with fixed interest rates, although there are cases where non-amortizing loans have fixed rates, too.

Amortized Loans

Amortized fixed-rate mortgage loans are among the most common types of mortgages offered by lenders. These loans have fixed rates of interest over the life of the loan and steady installment payments. A fixed-rate amortizing mortgage loan requires a basis amortization schedule to be generated by the lender.

You can easily calculate an amortization schedule with a fixed-rate interest when a loan is issued. That’s because the interest rate in a fixed-rate mortgage doesn’t change for every installment payment. This allows a lender to create a payment schedule with constant payments over the life of the loan.

As the loan matures, the amortization schedule requires the borrower to pay more principal and less interest with each payment. This differs from a variable-rate mortgage, where a borrower has to contend with varying loan payment amounts that fluctuate with interest rate movements.

Non-Amortized Loans

Fixed-rate mortgages can also be issued as non-amortized loans. These are usually referred to as balloon payment loans or interest-only loans. Lenders have some flexibility in how they can structure these alternative loans with fixed interest rates.

A common structuring for balloon payment loans is to charge borrowers annual deferred interest. This requires interest to be calculated annually based on the borrower’s annual interest rate. Interest is then deferred and added to a lump sum balloon payment at the end of the loan.

In an interest-only fixed-rate loan, borrowers pay only interest in scheduled payments. These loans typically charge monthly interest based on a fixed rate. Borrowers make monthly payments of interest, with no payment of principal required until a specified date.

Advantages and Disadvantages of Fixed-Rate Mortgages

Varying benefits and risks are involved for both borrowers and lenders in fixed-rate mortgage loans. What may be a benefit for one is often a drawback for the other. The following are the most common pros and cons of fixed-rate mortgages.

Advantages

Many consumers prefer fixed-rate mortgages because the rate remains constant for the life of the loan. This provides them with a guarantee that the loan won't change even if interest rates go up. It also provides borrowers with predictability since they always know how much they'll have to pay. This allows them to budget for other financial obligations.

Lenders also benefit from fixed-rate products. This is especially true when interest rates drop. In 2020 and 2021, the Federal Reserve's lowering of the federal funds rate brought mortgage rates down in response.

In environments where rates are suddenly low, lenders can profit from the higher interest payments made by borrowers on their fixed-rate home loans.

Disadvantages

Borrowers have no flexibility when it comes to interest rates or payments with fixed-rate mortgages. So when interest rates drop, fixed-rate borrowers end up paying more than people who have adjustable-rate mortgages.

Borrowers typically seek to lock in lower rates of interest to save money over time. When rates rise, a borrower maintains a lower payment compared to current market conditions. A lending bank, on the other hand, doesn't earn as much as it could from the prevailing higher interest rates—foregoing profits from issuing fixed-rate mortgages that could be earning higher interest over time in a variable-rate scenario.

The Bottom Line

Most of us can't afford to pay cash for our homes, which is why we need to take out mortgages. There are so many different products on the market for homeowners, so it's important to do your research to see which one fits your needs. Fixed-rate mortgages provide you with the security of knowing that your rate won't change and how much you'll have to pay. Keep in mind that you won't benefit if rates drop, which means you will pay more during an economic slowdown.