Fixed Rate Mortgage
Fixed Rate Mortgage
A fixed rate mortgage, or FRM, is probably the most simple and easy to understand type of mortgage. It is also by far the most popular mortgage type.
As the name implies, a fixed rate mortgage has a fixed interest rate for the term of the loan. The amount of the borrower's payment for principal and interest also remains the same for the term of the loan. At the beginning of the loan term, most of the payment is for interest and only a very small amount goes toward paying off principal. Over time, the amount of the payment that goes toward interest reduces, and and the amount applied toward the principal increases until at term the loan is fully paid off (referred to as fully amortized).
It is important to note that although the principal and interest payment remains the same for the life of the loan, it is possible for the amount that the borrower pays the lender to increase. This is because many borrowers also pay an escrow amount for taxes and insurance to their lender. Taxes and home owner's insurance typically go up over time. So in this case, the borrowers payment for principal, interest, taxes, and insurance (often referred to as PITI) will go up because of increases in the escrow payments. Typically, these increases are modest and fairly predictable.
Conforming and Nonconforming Fixed Rate Mortgages
Fixed rate mortgages may either be conforming, or non-conforming (also referred to as "jumbo"). A conforming mortgage is a mortgage whose loan amount is less than or equal to the loan limits set by the Federal National Mortgage Association (FNMA or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac). As of 2006 these limits are:
- 1-family loans: $417,000
- 2-family loans: $533,850
- 3-family loans: $645,300
- 4-family loans: $801,950
Please note: The loan limits for 1 to 4 family loans in Alaska, Hawaii, Guam, and the U.S. Virgin Islands are 50 percent higher.
A jumbo or nonconforming fixed rate mortgage is an FRM that is over these amounts.
Fixed Rate Mortgage Term
Fixed rate mortgages have a term, or the amount of time that it takes for the loan to be paid off (referred to as amortization). The most common terms for fixed rate mortgages are 15 and 30 years. Other terms, such as 10, 20 or even 40 years are also not uncommon. Typically, shorter terms have lower interest rates and higher monthly payments of principal and interest because the borrower is paying off the loan over a shorter time frame. The reverse is true for longer term fixed rate mortgages. They typically have higher interest rates but lower monthly principal and interest payments.
Fixed Rate Mortgage Points
Many advertisements for fixed rate mortgages will quote an interest rate and points. A point is equal to 1% of a loan's value (for example, for a $100,000 loan, 1 point would equal $1,000). Generally, the more points on a loan the lower the interest rate (for example, one loan may have an interest rate of 6.25% with 1 point, while another may be 6% with 2 points). In essence, points buy down the interest rate and may be thought of as prepaid interest (which is why points are included in the annual percentage rate or APR calculation that should also be present in all mortgage rate advertisements). Mortgages are available with no points, and typically a higher interest rate.
Fixed Rate Mortgage Options
There can also be numerous other "options" available for fixed rate mortgages which can introduce complexity. Some of the more prevalent options include:
- No cost loans - Some fixed rate mortgages may be advertised as "no cost" loans, in that there are no points and no closing costs. In reality, lenders are either rolling the closing costs into the loan amount, or charging a higher interest rate to cover the closing costs.
- Interest-only - An interest-only fixed rate mortgage is a mortgage where the borrower only makes interest payments for some period of time, typically up to five years. At the end of the interest-only period, the mortgage payment is adjusted to include principal and interest with the principal payment calculated to amortize over the remaining term of the loan.
- Bi-weekly payments - A mortgage that allows bi-weekly payments is a mortgage that you pay every other week, or 13 times a year, versus the normal 12 monthly payments a year. The advantage is that the loan will actually be paid off earlier than doing a monthly payment. This can be an option on a fixed rate mortgage up-front, or your lender may allow you to convert your monthly payment on your FRM into a bi-weekly payment. The lender will typically charge the borrower a fee to convert to a bi-weekly payment. A way to avoid such a fee is simply to make an extra 13th payment on your monthly payment FRM.
- Temporary buy down - similar to points, a temporary buy down is the payment of cash up front for a lower rate at the beginning of the loan. At some predetermined point in the future, the rate will revert to what it would have been. For example, if the loan rate is 7%, a 3-2-1 buy down would yield a rate of 4% in the loan's first year, a rate of 5% in the loan's second year, and a rate of 6% in the loans third year. In year four and beyond the rate would be the original 7%. A 2-1 temporary buy down would yield a 5% rate in year one, a 6% rate in year two, and back to the 7% rate in year three and beyond. Temporary buy downs on fixed rate mortgages are sometimes called "ARM alternatives" (adjustable rate mortgage alternatives) by lenders.
- Rate locks - Typically, the quoted interest rate and points will allow for a lock of the interest rate for some period of time before closing (usually 30 days). By paying additional points, borrowers can extend the period of the rate lock to 60 days and beyond.
- Less than full documentation - Typically, there are three types of documentation required to get a loan, income documentation, asset documentation, and employment verification. Some fixed rate mortgages will allow qualification with less than full documentation, with stated income and/or stated assets which are not verified, even with no documentation at all. Since these types of loans are riskier, lenders charge higher interest rates on these loans. As a rule of thumb, the less documentation provided, the higher the interest rate, also the higher the loan to value ratio (loan amount divided by the house value) the higher the interest rate.
Fixed Rate Mortgage Terms and Conditions
It is important for the mortgage consumer to be aware of some of the terms and conditions of fixed rate (and potentially other types of) mortgages. All mortgages have a "due on sale" clause, meaning that the loan comes due and must be paid off if the house is sold. Some mortgages may also have a "demand clause" which allows the lender to demand full repayment for any reason.
Another feature of some fixed rate mortgages is a prepayment penalty. A prepayment penalty is a cash penalty that you pay if you payoff the entire loan early. Prepayment penalties can be "hard", meaning that the penalty must be paid if the loan is paid off early for any reason including the sale of the home. There are also "soft" prepayment penalties where the penalty applies only to loans paid off by refinancing. Prepayment penalties typically decline over time and usually no longer apply after a loan is five years old. Many prepayment penalties still allow for partial prepayments.
It is important for the mortgage consumer to understand if these features are present in the loans they are considering. Consumers should ask if there is any prepayment penalty for the loan that they are considering, or if there is any clause for repayment other than the "due on sale" clause.
