A fixed-rate payment is an installment loan with an interest rate that remains constant throughout the loan’s duration. The payment amount also stays consistent, though the proportions allocated to interest and principal will vary over the life of the loan. Sometimes referred to as a ‘predictable payment’, it offers a stable way for borrowers to manage their finances without surprises.
Key Takeaways
- Consistent Payments: In a fixed-rate payment, the total amount due remains the same throughout the life of the loan, although the proportion that goes to interest and principal varies.
- Common in Mortgages: The fixed-rate payment is most often used in mortgage loans. Borrowers typically choose between a fixed-rate payment and an adjustable-rate payment.
- Variety of Options: Banks generally offer a variety of fixed-rate mortgage loans with slightly different interest rates.
How a Fixed-Rate Payment Works
Fixed-rate payment agreements are most commonly found in mortgage loans. Homebuyers usually choose between fixed-rate mortgage loans and adjustable-rate (ARM) mortgage loans. Adjustable-rate mortgage loans are also known as floating rate loans. Homebuyers must determine which loan type suits them better.
Banks typically offer a range of fixed-rate mortgage loans, each with varying interest rates. A homebuyer can often select a 15-year term or a 30-year term. Slightly lower rates are available to veterans and through Federal Housing Authority (FHA) loans. Although these loans have lower interest rates, borrowers may need to purchase additional mortgage insurance against default.
Historically, banks also offered adjustable-rate loans with initially lower interest rates than fixed-rate mortgages. In such arrangements, the initial months’ payments would be lower. When the introductory period ended, the interest—and subsequently, the payments—might rise. Over time, the gap between fixed-rate and variable-rate loans has narrowed down, especially following the 2008 housing crisis.
As of August 13, 2020, the average interest rate nationwide on a 30-year fixed mortgage was 2.96%, compared to a 2.9% rate for a comparable adjustable-rate loan, typically a ‘5/1 ARM,’ meaning the rate is fixed for the first five years and is adjusted annually thereafter.
Special Considerations
Though the amount paid each month under a fixed-rate payment loan stays the same, the proportions allocated to interest and principal change each month. Initially, more of the payment goes toward interest rather than the principal. Over time, the amount paying off the interest declines while payments on the principal increase, a process known as loan amortization.
Example of a Fixed-Rate Payment Loan
Consider a $250,000, 30-year fixed-rate mortgage with a 4.5% interest rate. The first few lines of an amortization schedule may look like this:
| Example of a Loan Amortization Schedule | |||
|---|---|---|---|
| Dollar Amounts | Month One | Month Two | Month Three |
| Total Payment | $1,266.71 | $1,266.71 | $1,266.71 |
| Principal | $329.21 | $330.45 | $331.69 |
| Interest | $937.50 | $936.27 | $935.03 |
| Total Interest Paid | $937.50 | $1,873.77 | $2,808.79 |
| Loan Balance | $249,670.79 | $249,340.34 | $249,008.65 |
Notice how the monthly interest payment decreases slowly from one month to the next, while the principal payment rises slightly. However, the overall loan balance declines steadily and consistently due to the unchanging monthly payment amount of $1,266.71.
Understanding fixed-rate payments can guide your financial planning by offering payment stability and predictability, ensuring you remain on solid footing through the life of your loan.
Related Terms: amortization, adjustable-rate mortgage, interest rate.
References
- Consumer Financial Protection Bureau. “Understand loan options: Interest rate type”.
- Consumer Financial Protection Bureau. “Understand loan options: Loan term”.
- Consumer Financial Protection Bureau. “FHA loans”.
- Freddie Mac. “Mortgage Rates Move Up”.
- Consumer Financial Protection Bureau. “Understand loan options: Understanding adjustable-rate mortgages (ARMs)”.
- Wells Fargo. “Loan amortization and extra mortgage payments”.
