Interest Rates and Amortization: Is A Fixed-Rate Loan Right for Me?

Buying a home is an exhilarating experience as you consider all the elements you need to create the perfect setting for your life and family.

But for most buyers, the biggest challenge is figuring out which mortgage product is right for you.

From fixed-rate mortgages to adjustable-rate mortgages, amortized to non-amortized, PITI to PMI, the lending universe is filled with esoteric terms and acronyms that make the process feel like you are trying to navigate a foreign country without understanding the language.

The good news is we are here to help explain the workings of the fixed-rate mortgage. We will define the terms, look at alternative products, and fully arm you with the questions you need to ask and facts you need to have to effectively evaluate your chosen lender’s offerings.

We’ve enlisted Richie Helali, loan officer and sales lead at HomeLight Home Loans, to help you understand the choices you will have to make and weigh the benefits and drawbacks of each.

What is a fixed-rate mortgage?

A fixed-rate mortgage simply means that the interest rate stays the same over the life of the loan.

Typically, fixed-rate mortgages are offered for specific terms or number of years — usually 10, 15, or 30 years.

The 30-year fixed-rate mortgage is by far the most popular of all mortgage products. The reason most homebuyers gravitate toward this loan is because your mortgage payment never changes (well, at least the principal and interest part), and paying the mortgage off over 30 years keeps the payments lower.

“If somebody has a mortgage today of $2,500 a month, it’s going to be the same 10 years from now or even 25 years from now,” explains Helali. Though it’s important to note that non-fixed costs like your property taxes and homeowner’s insurance can go up through the years.

“Over time, the cost of it is actually going to feel less with inflation. I always choose a 30-year fixed personally, because I just want that assurance of knowing what my payment is going to be.”

According to Helali, a fixed-rate mortgage also feels great if you see the interest rates going up in subsequent years. But what if five years later, you see the rates go down and are frustrated because you are locked into a higher interest rate?

“If rates go down, I recommend looking into a refinance to obtain a lower interest rate,” Helali says. “A borrower will have the power to do that so long as they have sufficient equity in their home, regardless of what type of rate they currently have.”

How does a fixed-rate home loan work?

The process for a fixed-rate home loan is pretty straightforward.

After meeting with two or three lenders to discuss interest rates and loan products, you decide which lender you want to work with. You submit an application to the lender, providing the information the lender needs to decide if it will lend to you, such as your income, and information on your assets and debts.

After evaluating your information and reviewing your credit score and documentation, so long as you meet eligibility requirements, the lender will approve you for a mortgage up to a certain limit — for example, $400,000 at 4% interest.

You purchase a $400,000 home, putting down 10%, or $40,000, and borrow the remaining $360,000 to finance your purchase. You agree to pay the loan off over the next 30 years.

Using the amount borrowed, the interest rate, and the 30-year term, the lender calculates what your monthly payment will be for the next 30 years to cover the interest plus the amount of principal you will pay off each month.

Principal and interest

• Amount of loan: $360,000
• Interest rate: 4%
• Term: 30 years
• Monthly payment: $1,719

This amount will never change over the lifetime of the loan. However, in addition to principal and interest, your monthly payment will likely also include mortgage insurance, homeowners insurance, and property taxes — and these costs can change with time.

Monthly tax and insurance payments

• Taxes: $320
• Homeowners insurance: $240
• Mortgage insurance: $150

Taxes and insurance are determined by where you live and the property you own, and they can change over time. Mortgage insurance or MI is a fee your lender will generally require if you put less than 20% down on a loan to cover their risk should you stop making payments on the loan.

All these fees added together — principal, interest, taxes, and insurance (PITI) — equals your monthly payment, or $2,429.

What is amortization?

Amortization simply means the rate at which you are paying off a debt, or the payoff schedule. When your loan is amortized, you will pay more toward interest at the beginning of the loan, and more toward your principal at the end of the loan term.

There are some great free amortization calculators online that will show you exactly how much of your payment each month goes to interest, and how much is paying off your principal.

Let’s go back to our example.

Your first monthly payment of $1,719 will include approximately $1,200 in interest and $519 towards paying off your principal.  By the time you make your final payment, 30 years later, that same payment of $1,719 will include $6 in interest and $1,713 in principal payment.

With such a large percentage of your payment going toward interest in the early years, you will be paying down your principal very slowly at first and then much more quickly in the final years.

Why is interest so high at the beginning?

Many people believe, incorrectly, that the lender frontloads the interest to make their money back faster. However, the reason there is such a high interest payment the first year is because you are paying 4% interest on the full $360,000 you borrowed, but by the year 10 or 20, you have paid down the principal and are paying 4% on a much smaller balance.

Interest vs. principal example

If you want to build equity faster, you can add $50 or $100 to your payment each month to pay down your principal more quickly. Paying down your principal sooner will reduce the total amount of interest you pay over the life of the loan.

According to Helali, there is also another benefit to paying down your principal faster than your loan’s amortization schedule.

“Any additional that you pay on top of your normal payment would go towards paying down your principal and that will shorten the term of the loan. So, if from the beginning you pay $100 extra each month, you’d expect to shave off several years of payments. So instead of having your mortgage paid off in 30 years, you would likely be paid off in 22 to 25 years.”

It would also allow you to reach 20% equity faster in order to eliminate the MI payments sooner.

Though make sure to look at your agreement with the lender to find out if you’ll owe a prepayment penalty for settling up the loan early (more on that soon).

What other mortgage loan products are available?

In addition to the traditional amortized fixed-rate mortgage, there are also interest-only and adjustable-rate mortgage (ARM) loans.

Before we dig into the details, there are a few things you need to consider upfront.

As you are deciding what type of mortgage you will apply for, you should carefully consider how long you plan to stay in the home. This may have a big impact on what mortgage product is best for you.

Second, look at your budget. What percentage of your current income are you willing to devote to a mortgage payment? Is your current level of income likely to change — and will it move up or down?

Next, study the mortgage interest rates. If mortgage rates are low, a fixed rate is probably your best option. If mortgage rates are high, you might want to consider other options.

Finally, talk to your lender and a financial advisor before making any decision.

“There’s information available online, which is great, and it lays out the different options available,” Helali said. “But there’s no graph that specifically says, ‘This is what someone in your exact shoes should do.’ That’s why it’s so important to talk to a loan officer so they can help you determine what is best for your specific circumstances.”

Adjustable-rate mortgage

An adjustable-rate mortgage (ARM) is a loan where the interest rate changes or adjusts over the life of the loan. Typically, the introductory or starting rate is lower than the current market rate, which means your mortgage payments will be lower during the first few years.

A typical ARM loan would include a 5-, 7- or 10-year introductory rate, with the rate then adjusting every 6 months to a year thereafter based on the current market rate. ARM loans are generally denoted by two numbers, such as a 5/1 ARM or 7/6 ARM.  These numbers are shorthand for the fixed period and then adjustment frequency of the loan. So a 5/1 is a loan with a fixed introductory rate for 5 years, then the loan will adjust according to an index every year thereafter.  A 7/6 ARM has an introductory rate for the first 7 years, but then will adjust according to that index every 6 months.

For a 5/1 ARM, “after the first five years, the rate will adjust based on market conditions once a year,” Helali explained. “When it reaches that adjustment period, you aren’t going to have a lot of time in advance to know what your new payment will be. About a month before that first new payment is due, you get a notice that your payments are going from, for example, $2,000 a month to $2,700 a month.”

“Going with an adjustable versus a fixed-rate mortgage may work if you know that you’re only going to be in the home for five years, so you may be selling and getting out of the mortgage before it begins to adjust upward,” Helali said.

Calculating the risk

An ARM loan is riskier than a fixed-rate loan because there is no way to know what will happen in the market in five years’ time, Helali notes.

When the real estate market tanked in 2008, many borrowers with ARM loans found themselves with larger mortgage payments as the rates reset every year, but they were unable to refinance or sell their home because it was worth far less than the amount of money they owed.

ARM loans have much more complex terms. If you decide that an ARM loan is the best option for your situation, you should verify each of these terms with your lender:

• Frequency: How often will my interest rate change after the introductory fixed-rate period?
• Index: What data will the lender use to decide what my new interest rate will be?
• Margin: How is the new interest rate calculated against the index?
• Caps: How much can my interest rate increase each adjustment period?
• Ceiling: Is there a maximum interest rate that I can be charged?

Interest-only or balloon loans

An interest-rate only, or balloon-payment loan offer, are non-amortized loans made at a fixed rate of interest, but instead of your monthly payment including interest and principal, you are only paying interest during all or a significant portion of your repayment period. When the loan comes due, you pay off all the principal in one, bulk payment (known as a “balloon payment”).

These loans are generally intended for a short period of time. The idea is that when the principal payment is due, the borrower will either sell the property or refinance into an amortized loan. These loans are rarely used by the average homebuyer these days, but are often used by real estate developers who intend to develop a property and quickly resell it.

“Non-amortized loans usually come from private lenders or private investors,” Helali says. “These types of loans will normally come with high fees and high interest rates. The one advantage is that it gives somebody in unusual circumstances the ability to purchase property.”

The advantage of an interest-only mortgage is that the payments at the beginning are lower than a fully amortized mortgage because you are only paying interest.

“But, when you finish the term of the loan, guess what? You get your final bill, and your final bill is the rest of the balance of the entire mortgage – the balloon payment,” Helali said.

“Now, granted, most people are not going to keep a loan for 30 years, so this interest-only type mortgage may sound attractive. Back when that program was popular, borrowers generally assumed they were not going to keep the loan for the full term and they’d be able to sell or refinance before the balloon payment came due and the problem would sort itself out.”

Unfortunately, history would reveal that market fluctuations added an unanticipated and significant element of risk to that way of thinking.

In 2008 when real estate values plummeted during the Great Recession, refinancing became nearly impossible for most borrowers. The sudden crash in real estate values meant homes were no longer worth what homebuyers had paid for them. With that, borrowers with interest-only or balloon payment loans were unable to pay off the loan when it became due, only compounding the problems in the market.

Helali said because of the risk and the unique features of non-amortized loans, they are rarely offered to the average homebuyer these days. They are usually reserved for special purposes or special investment types. He recommended borrowers with specific questions about non-amortized loans should consult with a loan officer and a financial advisor who specialize in these types of loans.

“At the end of the day, you want to talk to a professional who can look at your specific situation and discuss options,” he said.

There are also great resources available at the Consumer Financial Protection Bureau’s Know Before You Owe website.

Is there a penalty if I choose to pay off my mortgage early?

You can pay off a mortgage at any time, but be aware that you may have a prepayment penalty written into your mortgage agreement. A prepayment penalty is a fee that some lenders charge if you pay off all or part of your mortgage early.

In 2014, the Consumer Financial Protection Bureau (CFPB) established strict laws around the use of prepayment penalties. According to the CFPB’s website:

“Typically, a prepayment penalty only applies if you pay off the entire mortgage balance – for example, because you sold your home or are refinancing your mortgage — within a specific number of years, usually within the first three years. In some cases, a prepayment penalty could apply if you pay off a large amount of your mortgage all at once.”

If you pay off extra principal on your mortgage in small amounts at a time, then prepayment penalties do not normally apply, but the CFPB advises that you check with the lender to make sure this is OK.

Some loans are forbidden to carry prepayment penalties. If a lender does include a prepayment penalty on your loan there are restrictions.

• The prepayment penalty can only run for the first three years of the mortgage
• There are caps on how much of a penalty a lender can charge
• Lenders are required to offer an alternative loan that does not include a prepayment penalty
• Lenders must disclose what the penalties will be

Always remember to read your paperwork carefully so you understand all the terms of the loan!

Final considerations

As we have pointed out, a fixed-rate mortgage is most beneficial for someone who plans to stay in their home for a good length of time. Its primary benefits are a mortgage payment amount that does not change and considerable savings over the life of the loan if you lock in a low interest rate from the beginning.

The downside of a fixed-rate loan is that your initial monthly payments could be larger than other types of loans. Also, if interest rates fall, you could be overpaying.

No matter which mortgage product you are leaning towards, we invite you to discuss all of your options with your real estate agent, who may then assist you with identifying a loan officer, mortgage broker, or financial advisor that can help guide you to a final decision.

Header Image Source: (manny PANTOJA / Unsplash)