Unlike adjustable-rate mortgages, fixed-rate mortgages are not tied to an index. Instead, the interest rate is set in advance to an advertised rate, usually in increments of 1/4 or 1/8 percent. The fixed monthly payment for a fixed-rate mortgage is the amount paid by the borrower every month that ensures that the loan is paid off in full with interest at the end of its term.
The United StatesFederal Housing Administration helped develop and standardize the fixed rate mortgage as an alternative to the balloon payment mortgage by insuring them and by doing so helped the mortgage design garner usage. Because of the large payment at the end of the older, balloon-payment loan, refinancing risk resulted in widespread foreclosures. The fixed-rate mortgage was the first mortgage loan that was fully amortized precluding successive loans, and had fixed interest rates and payments. Fixed-rate mortgages are the most classic form of loan for home and product purchasing in the United States. The most common terms are 15-year and 30-year mortgages, but shorter terms are available, and 40-year and 50-year mortgages are now available. Outside the United States, fixed-rate mortgages are less popular, and in some countries, true fixed-rate mortgages are not available except for shorter-term loans. For example, in Canada the longest term for which a mortgage rate can be fixed is typically no more than ten years, while mortgage maturities are commonly 25 years. A fixed rate mortgage in Singapore has the interest rate fixed for only the first three to five years of the loan, and it then becomes variable. In Australia, "honeymoon" mortgages with introductory rates are common, but can last as short as a year, and may instead offer a fixed reduction in interest rate rather than a fixed rate itself. Furthermore, they are often combined with properties of flexible mortgages to create what is known as an Australian mortgage, which often allow borrowers to overpay to reduce interest charges and then draw on these overpayments in the future. The mortgage industry of the United Kingdom has traditionally been dominated by building societies, whose raised funds must be at least 50% deposits, so lenders prefer variable-rate mortgages to fixed-rate mortgages to reduce asset–liability mismatch due to interest rate risk. Lenders, in turn, influence consumer decisions which already prefer lower initial monthly payments. Nationwide Commercial recently issued a 30-year fixed rate mortgage as bridging finance.
Comparisons
Fixed-rate mortgages are usually more expensive than adjustable rate mortgages. The inherent interest rate risk makes long-term fixed rate loans tend to have a higher interest rate than short-term loans. The relationship between interest rates for short and long-term loans is represented by the yield curve, which generally slopes upward. The opposite circumstance is known as an inverted yield curve and occurs less often. The fact that a fixed-rate mortgage has a higher starting interest rate does not indicate that it is a worse type of borrowing than an adjustable-rate mortgage. If interest rates rise, the ARM will cost more, but the FRM will cost the same. In effect, the lender has agreed to take the interest rate risk on a fixed-rate loan. Some studies have shown that the majority of borrowers with adjustable rate mortgages save money in the long term but also that some borrowers pay more. The price of potentially saving money, in other words, is balanced by the risk of potentially higher costs. In each case, a choice would need to be made based upon the loan term, the current interest rate, and the likelihood that the rate will increase or decrease during the life of the loan.
Pricing
Note: Fixed-rate mortgage interest may be compounded differently in other countries, such as in Canada, where it is compounded every 6 months.
The fixed monthly payment for a fixed rate mortgage is the amount paid by the borrower every month that ensures that the loan is paid off in full with interest at the end of its term. This monthly payment depends upon the monthly interest rate , the number of monthly payments called the loan's term, and the amount borrowed known as the loan's :wikt:principal|principal; rearranging the formula for the present value of an ordinary annuity we get the formula for : For example, for a home loan for $200,000 with a fixed yearly nominal interest rate of 6.5% for 30 years, the principal is, the monthly interest rate is, the number of monthly payments is, the fixed monthly payment. This formula is provided using the financial function in a spreadsheet such as Excel. In the example, the monthly payment is obtained by entering either of these formulas: This monthly payment formula is easy to derive, and the derivation illustrates how fixed-rate mortgage loans work. The amount owed on the loan at the end of every month equals the amount owed from the previous month, plus the interest on this amount, minus the fixed amount paid every month. This derivation illustrates three key components of fixed-rate loans: the fixed monthly payment depends upon the amount borrowed, the interest rate, and the length of time over which the loan is repaid; the amount owed every month equals the amount owed from the previous month plus interest on that amount, minus the fixed monthly payment; the fixed monthly payment is chosen so that the loan is paid off in full with interest at the end of its term and no more money is owed. The vendor may sell off the fix element as a "fixed to floating" derivative. Look up "Black-Scholes" to see how this is done.
