Are you ready to enter the housing market? Congratulations! It’s a big step. Whether you’re a first-time homebuyer or real estate investor looking to purchase a rental property, there’s a lot to consider. And perhaps the most significant consideration is deciding what type of mortgage loan you will use to finance your purchase.
Fortunately, several types of mortgages are available for homebuyers and real estate investors. The most popular is a fixed-rate mortgage.
Here’s a quick guide to help you understand this type of mortgage. Use it to decide if a fixed-rate mortgage is the best loan to help you reach your financial goals.
What is a fixed-rate mortgage?
Rocket Mortgage defines a fixed-rate mortgage as a home loan “with a specific interest rate for the entire term of the loan.”
Simply put, the interest rate is fixed and doesn’t change. Hence the name – fixed-rate.
As with adjustable-rate mortgages, the Federal Reserve (Fed) and U.S. Treasury determine the interest rates for fixed loans.
These rate locks will be outlined in the loan’s disclosures.
With a fixed-rate loan, you get consistent monthly payments and don’t have to worry about market fluctuations.
Fixed-rate mortgages vs. adjustable-rate mortgages
An adjustable-rate mortgage (ARM) is one where the interest rate is fixed for a period and the interest rate changes after the reset date. ARMs are easier to qualify for and have lower initial interest rates and monthly payments. However, they come with a lot of risk to the borrower. They’re a good option for homebuyers and real estate investors looking for shorter-term investments.
Fixed-rate mortgages differ from adjustable-rate mortgages (ARM) in four key ways.
- The interest rate on a fixed-rate mortgage does not change over the loan’s lifetime. While ARMs have an initial fixed interest rate, they are adjusted after the reset period. With fixed-rate loans, this doesn’t apply. The interest rate remains the same throughout the loan’s term.
- The borrower’s monthly interest and principal payments do not change. That’s because they have fixed interest rates. As a result, these loans make it easier for borrowers to plan and budget around.
- Market conditions do not impact fixed-rate loans. That’s right! Because the interest rate doesn’t change, it’s not affected by economic conditions. That’s why many borrowers refinance their fixed-rate mortgages when interest rates drop.
- Amortization occurs throughout the life of the loan. Mortgage amortization is a term used to refer to the home loan payoff process. With fixed-rate mortgages, part of your monthly payment goes towards interest, and part goes towards the principal, which differs from ARMs.
For these reasons, fixed-rate mortgages are the most popular type of home loan in the U.S.
Terms of fixed-rate mortgages
A mortgage’s term refers to the life of the loan. In the U.S., terms can range from 10 to 30 years. Here’s a closer look at the most popular fixed-rate mortgage terms.
30-year fixed-rate mortgage
These are the most popular loan option for borrowers. They’re so popular that Investopedia says 30-year fixed-rate mortgages are the product of choice for nearly 90% of today’s homeowners.
Here’s why, according to U.S. Bank. They offer:
- Stability because the interest rate does not fluctuate as it does with an ARM.
- Smaller monthly payments because you spread the loan repayment over a more extended period.
- Ability to qualify for a larger mortgage because a lower monthly payment means a lower debt-to-income ratio.
- Financial flexibility because of the smaller monthly payment.
Here’s an example of what a 30-year mortgage is. We used Finder’s mortgage calculator tool and Freddie Mac’s current mortgage rates for the formulation.
Let’s say you want to purchase a home for $250,000. The lender offers you a 30-year fixed-rate mortgage with an interest rate of 6.92%. Over 30 years, you’d pay $343,944.58 in interest. Your total cost for your 30-year loan would total $593,944.58. Your monthly mortgage payment would be $1,649.85.
The total lifetime amount of the loan will be reflected as an annual percentage rate (APR) and outlined in the loan’s disclosure agreement.
A 30-year fixed-rate mortgage is an excellent option for homebuyers and real estate investors who want to keep their monthly payments low and plan to keep the home for the long term.
15-year fixed rate mortgage
A 15-year fixed-rate mortgage is just like a 30-year fixed-rate loan but with some key differences. They include:
- Ability to save money because the total interest paid is less than a 30-year mortgage.
- Ability to qualify for lower interest rates because 15-year mortgages aren’t as risky and cheaper for banks to fund than long-term loans.
- Higher monthly payments than a 30-year mortgage because the loan balance is paid off in a shorter period.
- Less financial flexibility because of the higher monthly payments.
Here’s an example of how a 15-year mortgage works to help you understand how it differs from a 30-year mortgage.
Again, we used Finder’s mortgage calculator tool and Freddie Mac’s current mortgage rates for the formulation.
Let’s say you want to purchase a home for $250,000. The lender offers you a 15-year fixed-rate mortgage with an interest rate of 6.09%. Over 30 years, you’d pay $131,927.11 in interest. Your total cost for your 15-year loan would total $381,927.11. Your monthly mortgage payment would be $2,121.82.
Compared to a 30-year mortgage, your payment amount increases by $497.97 a month throughout the term loan. But you’d qualify for a lower interest rate, save $212,017.47, and pay off your home loan in half the time. That’s not a bad deal.
A 15-year mortgage is a great option for borrowers who can afford to make higher monthly payments.
Other fixed-rate mortgage terms
While 30-year and 15-year terms are the most common, some lenders offer other fixed-rate mortgage terms. They can range anywhere from 5 to 30 years. A 20-year fixed-rate mortgage is probably the most common. It offers more affordability than a 15-year loan while paying it off ten years earlier than a 30-year loan. Talk to your lender to learn more about their fixed-rate mortgage terms.
How to qualify for a fixed-rate mortgage
Qualifying for a fixed-rate mortgage is much like qualifying for any other type. Here are some of the main items a loan officer looks at when reviewing a mortgage application.
Total household income is one of the first items a loan officer looks at. While there is no minimum income requirement, mortgage lenders want to see that a borrower has enough income to cover the mortgage payment, other bills, and debt.
A credit score is a three-digit rating that ranks your credit history. It helps lenders understand how reliable you are as a borrower. A high credit score means you pay your bills on time and have a lower debt-to-income ratio. It indicates that you’re a lower risk than a borrower with a lower credit score.
Your debt-to-income ratio (DTI) is a percentage that tells lenders how much of your monthly income goes towards paying off debt every month. Most mortgage lenders require a DTI of 50% or less to qualify for a loan. However, most financial advisors recommend having a DTI of 30% or less.
This will inevitably impact your DTI, and mortgage lenders want to see that a borrower isn’t taking on more debt than they can pay back.
Mortgage lenders want to know what type of property you’re buying – a primary residence, secondary property, or investment property. Why? Primary residences are less risky for lenders, and certain government-backed loans, like Federal Housing Administration (FHA) and V.A. loans, are only for primary residences.
Did you know you don’t need a 20% down payment to qualify for a fixed-rate mortgage? It’s true! Down payment requirements vary from lender to lender, but some only require 3%. However, it’s important to note that you’ll have to pay private mortgage insurance if you put less than 20% down on your home.
Private mortgage insurance
Private mortgage insurance (PMI) is a type of insurance that protects the mortgage lender if a borrower defaults on their loan.
Closing costs are fees a homebuyer pays to a lender for processing the loan. They typically include an appraisal, origination, attorney, and escrow fees. When determining how much home you can afford, be sure to factor these in.
Pros and cons of fixed-rate mortgages
Fixed-rate loans are the preferred financing option in the mortgage industry. And for a good reason. Here’s a look at some of the biggest pros and cons of fixed-rate mortgages.
Pros of fixed-rate mortgages
- Fixed interest rates: The name says it all. Fixed-rate mortgages come with fixed interest rates, giving borrowers stability and predictability.
- Consistent payments: Because of their fixed mortgage interest rates, a borrower’s monthly payment will remain the same throughout the life of the loan. The only things that can influence the monthly payment are property tax increases or an increase in homeowners insurance premiums. But those are outside of the lender’s control.
- Amortization occurs throughout the life of the loan: Mortgages, like all loans, have a set timeframe in which they must be paid off. Because of this and the fixed interest rate, borrowers know exactly how much money they will pay each month and throughout the loan. There’s no guessing or variability like with ARMs.
Cons of fixed-rate mortgages
- Harder to qualify for: Fixed-rate mortgages are riskier and more costly for lenders. As a result, they’re harder to qualify for than ARMs, where the borrower incurs more risk.
- Larger initial payments: Fixed-rate mortgages often have higher interest rates than ARMs initially. As a result, borrowers typically pay a little more upfront with fixed-rate loans than with ARMs. However, it’s important to remember that the interest rates on ARMs adjust over time which often means higher payments after the initial period.
- Duration of the loan: Many homebuyers and real estate investors don’t like being “tied” to a property for 15 or more years. Fixed-rate mortgages aren’t designed for short-term investments. They’re designed for borrowers who plan to keep a property for the long term.
Is a fixed-rate mortgage right for you?
It depends on your current financial situation as well as your financial goals.
Fixed-rate mortgages are an excellent option for first-time homebuyers buying a primary residence, homeowners wanting to move into a new home, or anyone who wants less risk, more predictability, consistent monthly payments, and plans to keep a property for an extended period.
The bottom line
Buying a home or investment property is a big financial decision. A fixed-rate mortgage can be a great way to finance homeownership or an investment. They offer a fixed interest rate and consistent monthly payments, which results in greater financial flexibility. However, they aren’t always the best option for borrowers looking to finance short-term real estate investments.
If you’re ready to invest in real estate but don’t want the hassle of a fixed-rate mortgage or any other type of mortgage, we can help.
With Arrived Homes, it’s easy to get started by purchasing shares in any of our rental properties for as little as $100, no matter your credit score. To get started, browse through our available properties on this page.