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What are the advantages of a fixed rate mortgage?

Fixed rate mortgages have an interest rate that is fixed for the life of the loan. Most fixed rate loans also have a payment that does not change during the loan term, and with each payment you pay interest, and some principal. Fixed rate mortgages which have an option to make an interest-only payment during the first ten years of the loan are discussed below. With a fixed rate mortgage, at the end of the loan term the loan has been paid off. The word mortgage comes from Old French, and literally means a pledge that dies.

Advantages

• Predictability–the payment does not change
• Security–the interest rate can never increase
• Saving–each month you build more equity in your home as your principal balance decreases

Disadvantages

• Higher rate–rates are higher for fixed rate mortgages than for ARMs and hybrid loans
• Higher payment–hybrids, interest-only loans, and ARMs will usually cost less each month
• Inflexibility–with a fixed rate loan you must pay principal each month; you do not have the option of making a lower, interest-only payment

For many Americans the 30 year fixed is an icon, and anyone who chooses another mortgage option is a wild-eyed financial gambler. It’s not that simple. Paying principal on a mortgage is not magic—it is a forced savings plan at a relatively low interest rate. This was very important many years ago when most people lived in the same house their entire lives, and before the advent of 401(k)s and IRAs. Today, as part of an overall financial plan, it can still be a good idea. However, I have many clients who are already contributing to a 401(k) or IRA, and who have other savings vehicles; they believe they are better off paying into a tax-advantaged 401(k) or IRA, or putting money in a high-return investment, rather than paying down the mortgage, and so they choose to pay interest-only. Over time they are confident that they will still build equity as their property appreciates, whether or not they are paying principal on their mortgage each month.

The most common fixed rate mortgages have terms of 15, 30, or 40 years; 10 and 20 year fixed are offered by some lenders as well. The interest rate increases slightly with the length of the fixed period—a 40 year fixed will have a slightly higher rate than a 30 year, a 30 year will have a slightly higher rate than a 15 year. However, the monthly payment increases sharply with a shorter fixed period.

• a $500,000 loan fixed for 15 years at 5.375% will have a monthly payment of $4052
• a $500,000 loan fixed for 30 years at 5.75% will have a monthly payment of $2918
• a $500,000 loan fixed for 40 years at 6.00% will have a monthly payment of $2751

Many lenders also allow you to make an interest only payment for the first ten years that you have a fixed rate loan. With a 30 year fixed, you would have 10 years at a relatively low payment, but for the last 20 years the payment would be substantially higher:

• a $500,000 loan fixed for 30 years at 5.75% would have an interest only payment of $2396 for 10 years, over $500 less than the amortizing (principal & interest) payment of $2918. However, beginning with year 11, the payment would jump to $3510—a 68% increase in the payment in one month. That is a big increase, but it is only a 4% annually compounded increase in the $2396 payment; in other words, if your income increases by 4% a year over the ten years, the payment jump should be affordable.

Also, if you choose the interest-only option, you can always pay as much principal as you choose each month.