Image courtesy of BeSmartee, The Beginner's Guide To Fixed Rate Mortgages
Unless you can shell out cash to buy a home, you will need to take out a home loan, or a mortgage. Although there are different types of mortgages available to consumers, such as a variety of adjustable-rate mortgages and balloon mortgages, the most popular is the fixed-rate mortgage, which is a fully amortizing loan, meaning that you get to spread out the debt in regular payments over time.
Your interest rate stays the same for the life of the loan with a fixed-rate mortgage, no matter whether interest rates rise or fall.
The Great Depression of 1929 to 1939 was the catalyst for the fixed-rate mortgage. Before that, people typically financed their homes by getting many short-term, variable-rate mortgages or refinancing every five years or so. During the Depression, however, many people lost their jobs and could not refinance their mortgages. That led to many banks and mortgage lenders going under during this time.
To provide relief, three government agencies were formed: the Home Owner's Loan Corp. (HOLC), the Federal Housing Administration (FHA), and the Federal National Mortgage Association (FNMA), which would later become Fannie Mae, an entity that buys loans from mortgage lenders and repackages them for sale as mortgage-backed securities to investors. The HOLC bought the short-term mortgages that people defaulted on and turned them into 20-year fixed-rate mortgages. The FHA insured the mortgage loans, so that banks would not be under such risk again.
By 1954, the standard fixed-rate mortgage went from 20 years to 30 years. The government heavily promoted fixed-rate mortgages at this time, while discouraging the other types of mortgages: adjustable-rate mortgages and balloon mortgages. In fact, some states had laws on the books that prohibited adjustable-rate mortgages.
With a fixed-rate mortgage, you know what you're getting — it is what it is. You don't need to concern yourself with whether interest rates are rising (or falling) because your rate is locked in. Even in times of extreme inflation, with interest rates as high as 21.5%, as they were in December 1980, your rate will stay the same as it was when you took out your fixed-rate loan.
U.S. interest rates were at an all-time high during December of 1980
The big advantage of having a fixed-rate mortgage is that you can create a budget. When you have a fixed-rate mortgage, your monthly payments will remain the same for the life of the loan. It's nice to have that sort of stability.
Fixed-rate mortgages, because of their simplicity, are easy for people to understand. Adjustable-rate mortgages that have a 10/1 ARM, a 7/1 ARM or a 5/5 ARM with maybe a 4/2/7 cap, just to give a few examples, are more difficult to understand. When a mortgage loan is difficult to comprehend, consumers might not make the best choice for their situation. This happens all the time when people take out a loan with a low interest rate in the beginning, for example. If that is all they can afford, they might not be able to make their mortgage payments when the rate adjusts up in a few years. That scenario doesn't happen with a fixed-rate mortgage.
If you have a fixed-rate mortgage and interest rates drop, you'll pay more for your mortgage than if you had an adjustable-rate mortgage. Also, if you plan to move in five years or fewer, you would probably save money by taking out an adjustable-rate mortgage since the interest rate you initially pay on adjustable-rate mortgages is typically less than what you pay with a fixed-rate mortgage. You'll then move before the rate adjusts up.
If you have bad credit, your interest rate on a fixed-rate mortgage will be high … if you can be approved at all. It also might be more difficult to afford a fixed-rate mortgage than if you were to get a more customized mortgage, such as an adjustable-rate mortgage. The reason is that the initial payments with an adjustable-rate mortgage are typically lower than they are with a fixed-rate mortgage. So, for example, if you're working a job and you are guaranteed a raise in a year, you'll know that, although you might not be able to afford higher payments now, you will be next year. In this case, a fixed-rate mortgage might not be right for you.
There are two basic types of fixed-rate mortgages: 30-year fixed and 15-year fixed. With a 30-year, fixed-rate mortgage, it will take you 30 years to pay the loan. Your payments will be the same for the next 30 years. The initial payments you make toward the mortgage will go mostly to the interest you owe, so it will take a while before you start building equity in the home. But the later payments you make will go more and more toward the principal. If you plan to be in your house for 10 years or more, a 30-year, fixed-rate mortgage would be a good option.
With a 15-year, fixed-rate mortgage, it will take you 15 years to pay the loan. Since you'll be paying the loan back in half the time with a 15-year mortgage than you would with a 30-year mortgage, your monthly payments will be much higher. However, they might not be twice as high because you generally get a better interest rate with a 15-year loan than you do with a 30-year loan.
If you can afford to get the house you want and take out a 15-year, fixed-rate mortgage instead of a 30-year, fixed-rate mortgage, you'll save money in the long run by paying less in interest. Here's a calculator from myFICO to help you determine which loan is better for you.
It's possible to get other terms on a fixed-rate mortgage, such as one for 10, 20, 40, or 50 years, but those types are far less common.
Just because a fixed-rate mortgage doesn't change, doesn't mean that everyone gets the same fixed rate. Many factors determine the rate you'll get, such as your credit score and the lending institution. Your goal is to get the lowest rate possible because the lower your interest rate, the lower the payments you'll make. Here are some tips on getting the best interest rate possible.
Work on your credit score: The higher your credit score, the lower your interest rate will be. A credit score of 760 and above should get you the best rate. You can probably qualify for a conventional loan if your credit score is between 620 and 760, but your interest rate won't be as good. If your score is lower than 620, you'll need to get an FHA loan. You'll need a score of at least 580 to qualify for an FHA loan.
Have a steady job: To qualify for a mortgage, you'll typically need to have been on the job for at least two years. If you've made a move in your company to a higher-paying job, that's usually looked on favorably by lenders. But if you just started a new job, even if it pays more than your last job, lenders typically like to see that you've been on the job for a while before they'll feel comfortable lending to you. If you're self-employed, you need to provide a lender with your tax returns for the past two years to prove your income.
Have a low debt-to-income ratio (DTI): Your lender will measure how much debt you have (minus your current rent and plus your proposed mortgage payment) compared with how much income you bring in. Your DTI should be no more than 36% to get a conventional loan. It can be as high as 43% to get an FHA loan. Another way to look at your debt would be to figure what percentage of your income your housing costs would require. Most lenders like housing costs to be no more than 28% of your income.
Save for a down payment of at least 20%: Although you can probably get a mortgage with a down payment of less than 20% — FHA loans require you put down only 3.5% — you'll get the best interest rate by putting down at least 20%. In addition, you won't have to pay for extra insurance, called private mortgage insurance, if you put down 20% for your down payment.
Have some money in savings: Open a savings account that is separate from your retirement account. This account should be one that you can withdraw money from easily with no penalties. Have at least two mortgage payments socked away in this savings account to show your lender to get the best interest rate.
Shop around: It might be convenient to get your mortgage loan from your financial institution, and you can start there. But find out what other lenders offer as well. Get several quotes before you apply for your mortgage. Interest rates vary among lenders.
If you have a fixed-rate mortgage and rates drop, or if you improve your financial picture, you will be paying more for your loan than you have to. At this point, you should look into refinancing.
When you refinance, you'll get a lower interest rate, and this will be your new rate for your fixed-rate mortgage. So it sounds as if refinancing is a no-brainer. But it isn't. There are costs associated with refinancing.
You'll need to pay closing costs, just as you did when you originally bought the house. You can expect to pay several thousands of dollars in closing costs. So you'll need to figure whether spending that money will be worth it. To do this, you'll need to figure out your break-even point. Let's say that your closing costs will be $4,000, but that $4,000 buys you a savings of $100 a month on your mortgage payment. It would take you 40 months to break even, or about 3 1/2 years. If you plan to sell the house or move before your break-even point, it would not be worth it to refinance. If you will stay in the house longer than the break-even point, it will probably be worth it to refinance.
Note that if you've been paying your mortgage for 10 years, for example, you have only 20 years left to go. When you refinance, you can start over with another 30-year, fixed-rate mortgage to get your monthly payments even lower, or you can refinance for 20 years, or even 15 years. Keep in mind that the longer you have a loan, the more you'll pay in interest over the life of the loan. So, for example, if you were to refinance to get a lower interest rate, but you lengthened the life of the loan by starting over at 30 years when you had only 20 years left to go, you might be paying more in total interest over time because you will have paid your mortgage for 40 years instead of 30.
There is also something called a cash-out refinance. People do that when they have equity in the home and want to use some of that cash. Let's say your home is worth $400,000 and you owe $250,000. That means you have $150,000 in equity in the home. Let's say you refinance your mortgage, which is now $250,000, and you take out $75,000 in a cash out refinance. You will get the cash to use for many different purposes, such as paying off credit card debt, making home improvements, going on vacation, buying a car, paying for college tuition, buying investment property or a vacation home, etc., but your mortgage will now be $325,000.
If you plan to refinance to get a lower rate, you might wish to consider getting some cash out of your home using the cash out refinance option. Your other option if you need cash and you have equity in your home is to take out a home equity loan. When you do that, you do not refinance your loan, so all your terms remain the same.
While it's true that you can count on the same monthly payments throughout the life of your fixed-rate mortgage loan, there are some qualifications. There's a common term regarding mortgages, called PITI. This stands for principal, interest, taxes, and insurance. Principal — the loan — and interest — what the lender charges you for the loan — remain the same. But taxes and insurance (of which there are two kinds) can vary.
Property taxes are usually factored into your mortgage payment, and they can go up or down (usually up). If they change, so does your mortgage payment.
Regarding insurance, there are two kinds that are connected with your mortgage: homeowners insurance and private mortgage insurance. Homeowners insurance pays out if there's a fire or other hazard at your home. It's always a good idea to buy homeowners insurance if you own a home. If your house is paid for, the decision of whether you wish to buy it or not is up to you. But if you have a mortgage, your lender will require you to carry homeowners insurance.
Homeowners insurance payments are usually added to your mortgage, and what you pay in homeowners insurance can vary. For example, if your area is facing a severe drought that could lead to wildfires, is having more tornadoes, or is experiencing other weather conditions, your premiums might rise. The same goes for an aging home. Homeowners insurance could go up once a home reaches older status since plumbing and roofing problems could mean damages to the house. If you made additions to the home, run a business from your home, or if your credit score drops, your homeowners insurance premiums could rise.
The other type of insurance referred to in PITI is private mortgage insurance (PMI). Unless you put down a 20% down payment, you'll need to pay PMI, which is typically between 0.5% and 1% of your mortgage loan. That means on a $200,000 mortgage, you could be paying as much as $2,000 a year, or $167 a month just for PMI. But as soon as you have 80% equity in the home, you no longer need to pay PMI, which would lower your fixed-rate mortgage payment.
The fixed-rate mortgage is a popular and common financial product. But it isn't the only type of mortgage out there. Now that you know all the ins and outs of the fixed-rate mortgage, you can better make a decision on whether it's the right type of mortgage for you.
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