A fixed rate mortgage (FRM) is a home loan with an interest rate that remains the same through out the term of the loan.
This means that without the complexity of ARMs and hybrids, a borrower can have a very clear picture of payments over the entire life of the loan by just having a few variables.
- Number of years
- Interest rates
- Loan quantum
- Compounding schedule
The compounding frequency would show the number of times the accumulated interest is capitalized or paid out each year.
With the above information, the monthly installment payment can be worked out.
The installments would make up a portion for interest and another towards the principal amount.
Unlike adjustable rate loans that are tied to an index rate to reflect market sentiments and movements over time, FRMs don’t have a floating component in which causes it to swing up or down.
Because committing to a fixed interest rate for 20 to 30 years is risky to a lender, FRMs tend to have a slightly higher interest rate compared to ARMs.
This is because a lender has to continue charging the same mortgage rate even if prime rates or interest rate in general rise above the interest rate of the FRM.
Also partly because of the perceived risks, lenders of FRMs tend to insert lock-in periods into such loans that charge penalty fees on borrowers should they redeem the loan prematurely within the first few initial years.
The lock-in commitment period deters a borrower from switching to another lender via refinancing the moment a better deal comes along.
This is because a lender would have incurred costs for underwriting the facility and would have made a loss should a borrower exercise an early redemption. The penalty fees would make up for it.
The risks the borrower carries is that interest rates continue to stay below the rate for his loan long into the future.
This means that he has volunteered to pay above the market for all those years.
The general wisdom is that if you forecast interest rates to rise in future, a fixed rate mortgage is the way to go. While if low and depressed interest rates are predicted for the future, an adjustable rate mortgage will be a more strategic choice.
Often affectionately referred to as a “vanilla wafer”, it is fully amortizing and is the preferred choice of borrowers who have a risk-adverse profile.
Stability and certainty are key decision factors.
However, in the case of balloon mortgages and interest-only loans, a mortgage can be a FRM yet non-amortizing as well.