What Is a Fixed-Rate Payment?
A fixed-rate payment is an installment loan with an interest rate that cannot be changed during the life of the loan. The payment amount also will remain the same, though the proportion that goes toward paying off the interest and paying off the principal may vary.
A fixed-rate payment is sometimes referred to as a "vanilla wafer" payment, presumably because it is very predictable and contains no surprises.
- 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.
- The fixed-rate payment most often refers to mortgage loans. The borrower must decide between a fixed-rate payment and an adjustable-rate payment.
- Banks generally offer a variety of fixed-rate payment mortgage loans, each with a slightly different interest rate.
How a Fixed-Rate Payment Works
A fixed-rate payment agreement is most often used in mortgage loans. Homebuyers generally have a choice of fixed-rate mortgage loans or adjustable-rate (ARM) mortgage loans. Adjustable-rate mortgage loans are also known as floating rate loans. Homebuyers typically can decide which loan type is the better choice for them.
A bank will generally offer a variety of fixed-rate payment mortgage loans, each with a slightly different interest rate. Typically, a homebuyer can choose a 15-year term or a 30-year term. Slightly lower rates are offered for veterans and for Federal Housing Authority (FHA) loans. Although loans for veterans and those available through the FHA have lower interest rates, borrowers are typically required to purchase additional insurance to protect against default.
Banks also offer options for adjustable-rate loans. Historically, these could have a substantially lower–or higher–starting interest rate than fixed-rate payment loans. In times when interest rates were low, the new home buyer could get an even lower introductory rate on an adjustable-rate mortgage. While this meant a break on the payments in the months immediately after the purchase, the bank had the ability to raise the rate and the payment amounts as interest rates overall rose. When interest rates were high, a bank may be more inclined to offer the break on the fixed-rate loans because it anticipated that rates on new loans would go lower.
However, with mortgage rates hovering below five percent since the 2008 housing crisis, the gap between fixed-rate and variable-rate loans has practically closed. As of May 2020, the average interest rate nationwide on a 30-year fixed mortgage was 3.52%, according to bankrate.com. The rate for a comparable adjustable-rate loan was 3.25%. The latter is a so-called "5/1 ARM," meaning the rate remains fixed for at least five years. After five years, it may be adjusted upwards annually.
The amount paid for a fixed-rate payment loan remains the same month after month, but the proportion of principal and interest changes every month. The earliest payments are made up of more interest than principal. Month by month, the amount of interest paid declines gradually while the principal paid increases. This is called loan amortization.
The term is used in the home loan industry to refer to payments under a fixed-rate mortgage which are indexed on a common amortization chart. For example, the first few lines of an amortization schedule for a $250,000, 30-year fixed-rate mortgage with a 4.5% interest rate look like the table below.
|Month||Month 1||Month 2||Month 3|
Note that the interest payment goes down from month to month, albeit slowly, while the principal payment increases slightly. The overall loan balance goes down. However, the monthly payment of $1,461.53 remains the same.