What is a Fixed-Rate Mortgage?
A fixed-rate mortgage loan is a type of credit that’s secured by real property; it can be a residential or commercial property. If a mortgage is a fixed-rate mortgage, it means that the borrower (the debtor) and the lender (the creditor) agree to the interest rate ahead of loan disbursement, and that rate will remain the same (hence a fixed-rate) for the duration of the loan term.
- A fixed-rate mortgage is a loan secured by real property, where the interest rate is determined ahead of loan disbursement; that rate does not change during the loan term.
- A fixed-rate mortgage protects the borrower from rising interest rates, and the predictability of payments makes budgeting and financial forecasting easier.
- Lower-risk borrowers tend to qualify for longer fixed-rate mortgage terms than higher-risk borrowers.
Loan Amortization vs. Loan Term
When a reducing (or amortizing) loan is extended to a borrower, the expectation is that it will be repaid to zero at some point in the future, after all the payments have been made. The period over which those payments are made is what’s called the amortization period. For example, a mortgage loan might amortize (or reduce) over the course of 25 or 30 years.
A loan’s term can be quite different from a loan’s amortization. For instance, a borrower could take a 25-year mortgage (amortization) but a 5-year or 10-year term. Listed below are some important things to know about a loan term:
- The end of the loan term is called maturity.
- Assuming no defaults or other breaches of contract, whatever fixed interest rate was agreed upon at the time of disbursement will remain in effect until loan maturity.
- The technical definition of “loan maturity” is that all funds are due upon maturity of the loan; however, it’s “implied” that the remaining exposure will be extended or refinanced at maturity as long as there hasn’t been any material change to the risk of the borrower or to the condition of the property.
Using our 25-year amortization/10-year term example, upon maturity (the end of year 10), the remaining credit outstanding would become a 15-year mortgage loan, but new terms (rate, payment frequency, time to maturity, etc.) would be negotiated based on prevailing market conditions and other competitive forces.
Fixed vs. Variable (Floating)
A fixed-rate mortgage loan is one where the interest rate remains fixed for the duration of the loan term, regardless of what goes on in the macroeconomic environment or with a lender’s “reference rates.”
Example: 10-Year Fixed Rate
With a variable (sometimes called floating or adjustable) rate loan, the borrower is quoted a spread over a “reference rate” (often called bank “prime”). The borrower’s spread will remain the same throughout the loan term; however, the reference rate is subject to change. The reference rate plus the spread equals a borrower’s “all-in” interest rate.
Example: 10-Year Variable Rate
Reference rates are typically informed by macroeconomic forces and central bank policy; they can change a lot over the course of a 5-year or 10-year loan term.
Understanding Mortgage Lending
In all instances, loan structure and pricing (mortgage or otherwise) is a function of two main factors:
- The borrower’s level of risk. For a personal mortgage, assessment criteria include household income, credit history, and the amount of cash available to be put down towards the property purchase.
- The nature of the underlying collateral security. For a mortgage loan, specifically, the underlying collateral is the property itself. Collateral with an active secondary market and longer useful life (like real estate) tends to command longer amortizations and more favorable terms.
All things being equal, a lower-risk borrower is going to get better pricing and will often be permitted to take a longer fixed-rate mortgage term.
Consider two example borrowers, borrower A and borrower B:
- Borrower A is a recent high school graduate looking for a student loan to go to college.
- Borrower B is a lawyer purchasing a property.
Borrower A is an inherently less attractive borrower (from the creditor’s perspective) – students have no income, they tend to be younger (therefore shorter credit history), and in this case, there’s no underlying asset to secure as collateral.
Borrower B is (likely) a high earner, is certainly older (should have a longer credit history), and there is a property to take as collateral. Borrower B is a much more attractive borrower and will likely command a longer fixed-rate mortgage term with better pricing.
Pros & Cons of Fixed Rates
Fixed-rate mortgages offer a number of benefits and advantages from a borrower’s perspective. These include, but are not limited to:
- Locking in a fixed rate for the entire loan term means that a borrower is protected from rising rates.
- It can be easier to budget and plan personal finances.
- It provides general peace of mind.
However, fixed-rate mortgages also come with some drawbacks. These include:
- In an environment where rates are dropping, borrowers with a fixed-rate mortgage will miss out on decreasing rates because they’re locked in.
- There are generally early prepayment penalties (sometimes called breakage costs) associated with paying out or refinancing a fixed-rate mortgage before its maturity – these can be quite expensive.
- A longer fixed-rate mortgage term can also be harder to qualify for (as noted earlier).
Thank you for reading CFI’s guide to Fixed-Rate Mortgage. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below: