When to Get a Fixed Mortgage
Excerpted from The Mortgage Answer Book by John J. Talamo ©2005
The fixed interest rate mortgage (FIRM) is the traditional way to finance a home. At one time, it was the only mortgage offered by most lenders. It is also the easiest to understand because there are no changes over the life of the loan. A FIRM has a set rate of interest requiring an equal payment for a specific number of years. Future fluctuation of interest rates has no bearing on the loan.
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Example: If you have a 30-year loan at 7% interest with a $1000 per month payment, that is it. You will pay $1000 per month every month for thirty years. Your interest rate will always be 7%. Even if you may make additional payments to reduce what you owe in order to pay the loan off sooner, your interest rate and payment amount will remain the same.
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When interest rates are low and you expect to keep your property for many years, it is the best loan you can get.
Why is the Interest Rate Always a Little Higher?
The problem with fixed-rate loans is the lender's problem. Interest rates may increase over the years, but not for your loan. Because of this, lenders will structure your loan to protect themselves. They will charge a higher rate of interest, and in many instances, higher fees than if you got a loan with an interest rate that would change (adjust) as market rates changed. A way of reducing the higher rate is by using a buydown. By paying more discount points, you can get a lower interest rate.
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Example: You have just sold your home and have $70,000 cash. The new home that you are going to buy only requires a $50,000 down payment. You do not trust yourself not to spend the other $20,000. You now have a choice. You can pay a larger down payment and reduce the amount that you borrow, reducing your monthly payment, or you could choose to buy down the interest rate to reduce your monthly payment.
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Your decision will be based on how long you intend to pay on the loan. There are too many different possibilities to cover here. Ask your real estate agent or financial advisor to figure out which is best depending on your specific situation. As discussed, the most important factor is to be realistic as to how long you will keep the property.
There are other considerations besides the interest rate. The cost of the loan (points and fees) will also figure into the mathematical equation as to how many years it will take to make up the additional costs of the fixed-rate loan.
The final consideration is the market. Looking at the market conditions for the latter part of 2004, you would have the following factors to consider.
• Interest rates are at historic lows.
• The country is out of recession and there is job growth.
• The price of oil is high and this creates higher prices for goods and services.
• The Federal Reserve Board, fearing inflation, has raised rates several times in recent months, which has not yet substantially affected rates for new mortgages.
These signs seem to point to higher future interest rates. How much higher and how fast the rates will rise is not known. Lenders also see these signs and price the difference between fixed rates and adjustable rates accordingly. If you are pessimistic and believe rates will raise quickly, you want the fixed-rate loan. If you think the high oil prices will cause another recession and the rates will remain stable or even go down, maybe the adjustable is right for you. With its lower initial rate and the length of time it may take to adjust to a level higher than the fixed mortgage (plus taking into consideration your savings over the time period when the adjustable rate was lower than the fixed rate), this can offer significant savings in the short run.
There is an advantage to a fixed-rate loan that does not show by just comparing numbers. A fixed-rate loan gives you peace of mind. If rates go up, you are safe. If rates go down, you refinance. Unless you are fairly sure that you will not be in your home five years from now, you are usually better off to get the fixed-rate loan. Here is the problem: you plan to move in five years, so you get an adjustable rate loan. However, rates increase substantially. You now are ready to move up to your next home, which is bigger and more expensive. With the higher prevailing rates, you may no longer qualify or it may be just a bad time to get a new loan.
The decision as to whether to get a fixed or adjustable loan gets harder There are not just adjustable loans, but combination or hybrid loans that are fixed for a period of years and then adjust. There are also adjustable loans that will rise or fall quickly and ones that will react much slower to rate changes. As these loans are discussed later, you will see that there are many factors to take into consideration when deciding between the different loan options.
Things to Know
Most fixed-rate loans are not assumable. They will contain a due on sale clause. This clause will say that if you sell your property, you must pay off your loan. They may also contain a prepayment penalty. This protects the lender against falling interest rates, since you are most likely to pay off the
loan by refinancing if rates drop dramatically.
An important question to ask about any loan concerns making additional principal payments. An additional principal payment means that you pay more than the required amount of your monthly payment. This extra money reduces what you owe. It does not go to lessen next month's payment. Since your interest amount is based on what you owe (your declining balance), you will pay less interest on future payments.
Prepayment penalties can cover additional payments as well as paying off the loan in full. For example, this prevents you from quickly paying down your $200,000 loan to $50,000 and then making only required payments.
Another question you should ask is how much extra you can pay each month. Before the computer, lenders required that you pay additional principal payments in specified increments, such as a double payment or $100 increments. Since the computer can figure out whether you paid $100 extra or $3.57 extra without difficulty, there is no longer a reason for increments. If your lender requires specific increments, it will make additional payments more difficult for you.
Additional principal payments are especially important when rates are high. For example, on a $100,000, 30-year loan, with a rate of 8.5%, an additional principal payment of $25 per month would reduce the term from thirty years to twenty-six years, three months. An additional monthly payment of $75 would reduce it to just over twenty-one years, six months. Even when rates are low, it helps. A $25 additional payment on a 5.5%, $100,000 loan would reduce the term to twenty-seven years.
