Most mortgages currently available fall into one of two broad groups: fixed rate and adjustable rate. While adjustable rate mortgages do have their uses, fixed rate mortgages are a good option for some people. Before arranging a mortgage, it is a good idea to be sure that you understand the fixed rate alternative and how it works.
Terms and conditions of a fixed rate mortgage
A fixed rate mortgage offers borrowers a guaranteed interest rate that will neither increase nor decline, no matter what happens in the general economy. Interest may be calculated in a variety of ways, including daily compounding or continuous compounding, with the latter arrangement resulting in slightly more interest than the former.
Some fixed rate mortgages impose an early-payment penalty on borrowers: if they pay off the loan early, a fee will at least partially recoup the interest they would otherwise have avoided. Other financial institutions allow borrowers to pay in advance up to a certain limit or impose no restrictions at all on this practice. Borrowers must check with their mortgage lender to know which arrangement will apply.
Who benefits from a fixed rate mortgage?
A fixed rate mortgage is most advantageous to those who borrow to buy a home when interest rates are low. Choosing a fixed rate loan allows these borrowers to lock in their low rate. Since monthly payments are calculated largely according to the interest rate charged on the loan, a fixed rate mortgage produces a steady payment amount that does not vary from month to month, even years after the loan has first been originated.
This is an ideal situation for those who are on a fixed income; such individuals will be able to know in advance that their mortgage payment is affordable. If a mortgage interest rate is adjustable instead, then when interest rates increase, so will the required payments on the loan. The recent ‘mortgage meltdown’ in the US economy led to many foreclosures when homeowners could no longer afford to pay their increased monthly mortgage payments. This is not a danger when a fixed rate loan is selected instead.
How can consumers know if a fixed rate mortgage is a good option?
A refinance to a fixed rate mortgage is generally a good option for those who currently hold an adjustable rate mortgage, as long as two key conditions are met. First, the fixed rate mortgage should be at a lower rate than the current adjustable rate level by at least one percentage point. Second, the homeowner should be planning to stay in his or her house for at least five more years. If this is true, then the fees involved in refinancing will be less than the savings produced by the refinance, which makes the refinance itself a viable option. If a homeowner is planning to sell the home in substantially less than five years, then refinancing to a fixed rate loan may not make sense.
If the mortgage is a new one then a fixed rate mortgage is a good idea if rates are currently low, as is the case today. Likewise, it is a wise option whenever the future of the economy seems uncertain, since that may indicate that future rates will be higher.