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Fixed Rate Mortgages Explained in Plain English

in Mortgages

Fixed rate mortgages have been the most popular type of home loan in the U.S. for many decades. They allow the home buyer to lock an interest rate into place permanently. The size of the payment never changes over the entire twenty, twenty-five, or thirty year life of the mortgage. However, as the home buyers advance in their careers and the value of money decreases through inflation, the mortgage payment becomes less and less of a financial burden.

In a typical family, this works out conveniently. By the time the children are starting at university, the mortgage payment has gone from a large percentage of the parents’ income to a small one. The parents have the financial resources to help the children through this expensive and demanding time of life. This is almost guaranteed to work out, because there is nothing unexpected that can happen to the mortgage. With everything clear from the outset, it is possible for families to make long term plans with confidence.

The Difference Between Fixed and Variable Rates

While fixed rate home loans have always been popular in the U.S., they have not always been easy to access in the U.K. In the U.K., variable rate mortgages are the standard. Variable rate mortgages have to be refinanced frequently, and the interest rates are linked to the financial markets. If interest rates are low, then the mortgage payment will be low. However, if interest rates soar, then mortgage payments may rise precipitously. This guarantees that banks will always be able to take advantage of rising interest rates, and that mortgage holders will benefit from falling interest rates.

Right now, interest rates have nowhere to go but up. Borrowers who finance their mortgages at a variable rate will almost certainly see their payments increase in the future.

What to Look for in a Fixed Rate Mortgage

Fixed rate mortgages are currently being offered at a higher interest rate than variable rate mortgages. That’s to increase short term profits and decrease the financial risk to the banks that offer them. Of course, the best fixed rate loans are the ones with the lowest interest rates.

The risk borrowers take with a fixed rate loan is that interest rates will remain very low indefinitely, trapping them in a higher interest rate than they would have paid otherwise. The risk to a bank is that interest rates will skyrocket, but the fixed rate mortgages they hold will never reflect that.

On the other hand, fixed rate mortgages are now being offered by top banks at less than 5% interest. Back in the 1980s, mortgages were being financed at 15% interest or more. If that type of interest rate returns, borrowers will be relieved to have a fixed rate loan that they financed now, with interest rates lower than they’ve ever been before and perhaps ever will be again.

Borrowers who hold variable rate mortgages could see their payments become unaffordable if interest rates skyrocket. As an example, a 30 year loan of £200,000 at 5% interest requires a monthly payment of approximately £1000. If the interest rate increases to 15%, the payment will be over £2,500 a month.

Is it Possible to Refinance to Fixed-Rate?

It is possible to refinance an existing loan to fixed-rate at the time when the loan is scheduled to be renegotiated. However, with today’s extremely low interest rates, the higher interest rate on a fixed rate home loan will almost certainly increase the existing monthly payment, and it’s important for borrowers to keep that in mind and to balance the higher level of financial security with the more expensive payments they’ll be making in the short term.

For example, if a borrower who currently pays 2.5% under a variable interest, £200,000, 30 year mortgage refinances it to a 5% fixed rate loan, then the payment will increase from £790 to just over £1000 a month.

Borrowers who choose fixed rate home loans know that the cheapest choice now is not necessarily the best choice for the future.