Fixed Rate Mortgages

Choosing a mortgage that fits your budget and lifestyle means choosing the right type of mortgage rate. Over the years, there have been as wide a variety of mortgages as there are flavors of ice cream.  If you choose the right one for you, you can find one that’s just as sweet.

The easiest and most vanilla of all mortgages is the fixed-rate mortgage (FRM), where the interest rate is determined at closing, and you pay the same monthly amount throughout the term of the loan. The most common fixed-rate mortgages have a 15- or 30-year duration, and account for 75 percent of all home loans. The alternative to a fixed-rate loan is an adjustable-rate mortgage (ARM), which offers an interest rate that fluctuates based on current market conditions. The most common reason why someone would choose an adjustable-rate over a fixed-rate loan is because the latter will have a higher interest rate. The problem with an ARM, though, is that the rate is constantly changing, which means that your mortgage is unpredictable and harder to budget for, and could put you on a rocky road.

When interest rates are low, the fixed-rate mortgage is an easy choice. If your income is stable or increasing, and if you plan to own your home for 10-years or more, there’s probably no better deal available. A thrifty family, who purchases their dream home and pays off their 30-year fixed-rate mortgage while raising 2.5 kids and a dog, is most likely enjoying a comfortable retirement after selling their home and moving to Florida.

During the past several years, fixed-rate mortgages have been at historical lows. People have been locking in rates of between 4 and 5 percent, and will pay that rate for as long as they keep their mortgages. Consider this in an historical context. In the 1980s, Americans were suffering under the strain of double-digit interest rates, which remained for nearly a decade. According to Freddie Mac’s Primary Mortgage Market Survey, rates on a 30-year fixed rate mortgage reached as high as 10.13 percent in 1990, and a whopping 16.63 percent in 1981. Interest rates even inched above 18 at one point. You can see why people who lived through those years are constantly encouraging their friends and family to take advantage of the opportunity to get a fixed-rate mortgage, or refinance into one, when interest rates are in the single digits.

Fixed versus adjustable rate

With an adjustable-rate loan, the interest rate is pegged to a particular economic indicator, such as the Constant Maturity Index (CMI), treasury bills, the prime rate, or the London Interbank Offered Rate (LIBOR). The terms of each particular loan can vary wildly, and often feature very low introductory rates for a specified duration of three, five, or 10 years. These variable-rate mortgages can be a godsend for young couples starting out who expect to see their income grow quickly, but don’t currently have a high enough income to make a high monthly mortgage payment. When they choose an adjustable-rate mortgage, they will begin with low promotional rates and, hopefully, by the time their rate rises, their income will also have risen, so the increased monthly payment won’t be a problem. Unfortunately, an ARM can be a disaster if rates go up and the family income falls.

The biggest challenge with ARMs is that they just aren’t predictable, so it’s hard to create a long-term financial plan. Fixed-rate loans don’t change, and provide stability.

Advantages of fixed-rate loans

While they may cost more in the early years, fixed-rates loans have numerous advantages.

1.    They are simple and easy to understand when compared to ARMs. You don’t have to worry about how frequently your interest rate will change, the rate cap, the financial index it’s based on, how the payments are structured, how the rate is calculated, and if it can go into negative amortization.
2.    They offer security for buyers, and are appropriate for first-time homeowners.
3.    They are well suited to people who like to know what their monthly expenses are going to be, and for those who wish to keep their homes for a long period of time.
4.    Fixed-rate mortgages offer protection from inflation, which is the rise in the cost of goods and prices over a period of time. With inflation, you’re paying more money, but not getting any more goods, and the value of your dollar is reduced. But your interest doesn’t change with a FRM so, in a sense, you’ll be paying less for your mortgage.
5.    During periods of low interest rates, you can make an interesting financial move by prepaying the principal of your fixed-rate mortgage. If, for example, you have a mortgage rate of 6 percent, each time you make a prepayment of principal, it’s equivalent to getting a 6 percent return on your money. In a low interest rate environment you may be getting only 1 or 2 percent in a savings account or CD. During such times, it’s beneficial to prepay.

Disadvantages of fixed-rate mortgages

Fixed-rate mortgages are not all peaches and cream. There are some disadvantages when compared to other types of loans.
1.    Fixed-rate mortgages generally charge higher rates of interest than ARMs when considered in the short-term. However, if interest rates rise over the years, the rate of the FRM may ultimately be much lower than that of an ARM.
2.    Fixed-rate mortgages usually have higher initial monthly payments compared to those of a comparable adjustable-rate loan.
3.    They offer less flexibility than ARMs.
4.    Because interest rates on fixed-rate loans tend to be higher, resulting in a higher monthly payment, you may not qualify for as large a mortgage as you would with a loan that offered a lower monthly payment.

Choosing the right mortgage

How do you decide which mortgage type works best for you?

While it’s impossible to see into a crystal ball, it’s important to have some sense of where you’re going in your life. If you intend to be in your home for only a short time, like three or five years, an adjustable-rate mortgage may be better. In that situation, you can take advantage of the lower rates that are offered in the initial years of an ARM.  Some people choose to take advantage of the low rate and then refinance when the rate adjusts, as many tried to do right before the mortgage crisis broke out. The problem for them was that their home values dropped, and they couldn’t refinance. Many of these people ultimately found themselves in foreclosure.

If you intend to be in your home for 10 years or more, you will be able to take advantage of all the benefits that a FRM offers.

Another factor in choosing which loan is best for you is your income. If you work in a field where your income is based on commissions -- meaning that you’re not generating a steady flow of predictable cash -- an ARM, with its smaller monthly payment, may make it easier for you to manage your monthly outlays.  If you’re lucky enough to receive a large amount of cash, consider paying down your principal balance. Then, when interest rates drop, or it’s time for your ARM to reset, you can refinance into the more comfortable fixed-rate mortgage.

The final factor to consider is how much risk you can tolerate. If you’re the type of person who stays up late at nights worrying about money, an ARM is not right for you. Many people find more peace of mind with a fixed-rate mortgage, because they know what tomorrow’s payment will be.

Getting the best fixed-mortgage rate

No matter what the economy is going through at any given moment, there are things you can do to make sure that you get the best rate available. In the long run, the lower the rate, the more you will ultimately save if inflation causes rates to rise.

1.    Diligently maintain a good credit crating. The higher your credit score, the better your rate will be. Lenders are looking for people with a FICO score over 750. In order to achieve this, you’ll need to pay your bills on time – always – and keep your debt to credit ratio relatively low. Review a copy of your credit report, which you can get for free at annualcreditreport.com, and make sure that there aren’t any errors. If you find any, take steps to correct them immediately, and make sure the changes are made before you apply for your mortgage.
2.    Have 20 percent in cash to use as a down payment. You’ll need to prove to a lender that you can comfortably make a 20 percent down payment to be considered for the best rates.
3.    Avoid jumbo loans. A jumbo loan is one that is higher than the limits for a “conforming” loan. The range where a conventional loan ends and a jumbo begins is between $417,000 and $729,750. Check the limits in your area, and make sure that the fixed-rate loan that you apply for is under the conforming limit. Otherwise, you will pay a higher interest rate.
4.    Pay points. Points are 1 percent of the loan amount. By paying them, you can lower your mortgage rate.
5.    Don’t be a debtor. Lenders will do a thorough analysis of your financial situation. If you have a lot of debt relative to your income, you will look more like a high-risk borrower and not like an appealing candidate for a fixed-rate loan.

Fixed-rate mortgage documents

The application process is pretty simple, but it’s best to be prepared. Once you decide which lender you’ll want to use, they will provide you with an application form. In addition to the application fee, you’ll need the following items:

1.    Copies of bank statements for several months, and the account numbers for any other bank accounts you own.
2.    Proof of income, which can be in the form of pay stubs.
3.    Self-employed individuals will need to provide two to three years of tax returns to show proof of income.
4.    Evidence of your current mortgage or rental payments in the form of cancelled checks.
5.    Verification of your down payment. This can be a statement from the bank where you’re holding the funds.

Locking in your rate

Once you find the terms and interest rate that are the most favorable, you’ll want to make sure that they are still available by the time you close. Because interest rates change daily, it’s possible that your rate can go up. (Then again, it’s also possible that it can go down  -- but that’s a risk only you can decide how to handle.) But if you like what you see, it’s a good idea to ask the bank to give you a lock-in commitment, which will generally apply for 30 to 60 days.

If you choose to lock in your rate, make sure you get it in writing. An oral commitment from a loan officer will not do the trick if there’s any dispute about the rate. Some lenders may charge a fee for the privilege of locking in a rate, and may not refund it if the loan does not close within the specified period.

The lock-in period should give you and the bank time to get all approvals necessary to close. If you don’t close within the specified time frame, you will most likely lose the interest rate and points, unless they are still currently available.  If your lock does expire, you will have to start the process all over again, based on the prevailing interest rates at that time.

Closing Expenses

It’s not enough to know just the interest rate and the term of the loan – you also need to know how much the loan will cost. The bank will give you a Good Faith Estimate (GFE) within three days of your application for the loan, which will show you an estimate of your closing expenses. However, it is only an “estimate,” and the costs could significantly change by the time you actually hit the closing table. Here are some tips to determine your closing costs.

1.    Points. If you want to lower your interest rate, you may have the option to pay points, which are fees paid to the lender to buy down your rate. Each point is generally 1 percent of the mortgage amount. The more points you pay, the lower your rate will be.  Always ask that the lender give you a quote for the actual dollar amount as opposed to the number of points, so you can clearly understand what you’ll be paying. You’ll be required to pay your points at closing.
2.    Application and Underwriting fee. The cost of processing your loan. It should also include the costs of your credit report.
3.    Appraisal fee.  In order to determine the value of your home, the bank will order an appraisal. You’ll be required to pay the fee at closing.
4.    Title insurance. With every mortgage, you will need to pay for a title search and insurance. The title company will do research to make sure that there are no liens on your property, and will insure the lender in case there are any errors.
5.    Other expenses. Additional costs that you may be required to pay for, which can include recording fees, tax service, pest inspection, flood certification, and a survey, if required.
6.    Attorney’s Fees. Not only will you be required to pay for your attorney, but the bank will generally likely charge you for theirs, as well.