Why Fixed Rate Mortgages are Popular
Fixed-rate mortgages have been the mainstay of the home loan industry for decades. Over the years, loan-to-value ratios have fluctuated and interest rates have moved up and down, but the security a fixed-rate mortgage offers has never lost its appeal.
The word "mortgage" comes from the French. Mort means dead and gage means pledge. It's been argued that if the mortgagor (borrower) did not pay the debt, the property was dead to the owner because the mortgagee (lender) would reclaim the land used as security. If the debt was paid, then the pledge was dead. But those funny, silly French. Who really knows what it originally meant back in the 1500s?
What is a Fixed-Rate Mortgage?
Fixed-rate mortgages allow for repayment of a debt in equal monthly mortgage payments over a specified period of time, from 10 to 50 years. A 30-year amortization period is most common.
- Payments are credited first to interest, then to principal.
- During the early years of the loan, much of the monthly payment goes toward interest.
- Toward the end of the loan period, much of the monthly payment goes toward principal.
- Yikes, please realize, though, a $200,000 amortized loan at 6% for 30 years means you will pay $231,676 in interest over the life of the loan.
Fixed-Rate Mortgage Benefits
Borrowers gravitate toward fixed-rate mortgages in-lieu-of adjustable-rate mortgages because they like the security of knowing exactly how much they will pay per month for principal and interest. The interest rate is fixed, so if overall interest rates increase, it does not affect the fixed-rate borrower.
Likewise, if overall interest rates decrease, the borrower's payment still remains the same unless the borrower chooses to refinance the mortgage into a lower rate. A borrower can choose to make a larger monthly payment and direct the additional portion of the payment to be paid toward principal, thereby decreasing the principal balance of the loan faster. Paying half your monthly mortgage every two weeks pays off your mortgage in about 22 months. One extra payment per year reduces the amortization period to about 26 months. But additional principal payments are not required.
Should You Pay Points?
You can buy down your mortgage for the first few years by paying a lump sum to the lender. But unless the seller or somebody else is paying this fee for you, it doesn't make much sense to buy down your own mortgage. You can sock away the money in your own savings account and use that money every month, on which you earn interest, to help pay your own mortgage payment.
Points will decrease your interest rate. Each point is equal to 1% of your loan. To recover the cost of those points, figure out the monthly savings with the lower interest rate versus the rate without points. Then divide that number into your points to arrive at the number of months it will take you to break even. Everything after that is gravy.
For example, say you are paying 2 points on a $200,000 loan to get an interest rate of 5% with a payment of $1,074. Or you could get that $200,000 loan at an interest rate of 6% without points and pay $1,200 per month. The difference between the two payments is $126.
Two points will cost $4,000. To recoup that investment, $4,000 divided by 126 equals almost 32 months. By your 33rd month, after almost three years of payments, you will begin to profit from paying those points.
Collection for Taxes and Insurance
If you are considering a loan that is higher than 80% of the purchase price of your new home, you will likely be asked to pay monthly property taxes and homeowners insurance to your lender. Your lender, in turn, will pay the tax assessor and your insurance company. In this case, your monthly PITI will change from year to year as annual taxes and insurance go up or down.
- Lenders will also collect a reserve, from 2 to 8 months of taxes and insurance, in advance from you.
- This impound account reserve (sometimes referred to as an escrow account) will increase your closing costs.
- The reserve amount collected depends on the time of year and when your annual tax bill is due.
Even if you are putting down 20% or more of the purchase price, often lenders will charge "1/4 point to rate," meaning you will pay .25% more in interest NOT to set up an impound account. Personally, I prefer to be responsible for paying my own taxes and insurance.
As a hedge against interest rates falling, lenders who make fixed-rate mortgages will sometimes demand a loan feature known as a prepayment penalty. This means if you pay off the loan within a certain number of years, typically one to five years, you will also pay the lender an additional six months of interest, or more.