Fixed-Rate Payment

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What is a fixed rate payment?

A fixed rate payment is an installment loan with an interest rate which cannot vary during the term of the loan. The amount of the payment will also remain the same, although the proportion that goes to interest and principal may vary.

A fixed rate payment is sometimes called a vanilla chip payment, possibly because it contains no surprises.

How a fixed rate payment works

The fixed rate payment is most often used in mortgage loans. Homebuyers typically have a choice of fixed rate or variable rate (ARM) mortgages. The adjustable rate is also called the variable rate. The buyer must decide which is the better choice.

A bank will usually offer a variety of fixed rate mortgages, each with a slightly different interest rate. As a general rule, a buyer can choose a duration of 15 years or a duration of 30 years. Slightly lower rates are offered for veterans and for Federal Housing Authority (FHA) loans, which include default insurance.

There will also be options for variable rate loans. Historically, these could have had a significantly lower or higher starting rate than fixed rate payment loans. At a time when interest rates were low, the new home buyer could get an even lower introductory rate on an adjustable rate mortgage. This meant an interruption in payments in the months immediately following the purchase, while the bank had the option to increase the rate and payments while interest rates generally increased. When interest rates were high, the bank was inclined to offer a break on fixed-rate loans, as it anticipated lower rates on new loans.

However, with mortgage rates below 5% since the 2008 housing crisis, the gap between fixed rate and floating rate loans has practically narrowed. In April 2019, the national average interest rate on a 30-year fixed mortgage was 4.03%, according to bankrate.com. The rate of a comparable floating rate loan was 4.02%. The latter is an “ARM 5/1”, which means that the rate remains fixed for at least five years, then can be adjusted upwards annually thereafter.

Special considerations

The amount paid for a fixed rate loan remains the same month after month, but the proportion of principal and interest changes each month. The first payments are made up of more interest than the principal. Month after month, the amount of interest paid gradually decreases while the principal paid increases. This is called loan amortization.

The term is used in the mortgage industry to refer to payments made under a fixed rate mortgage that are indexed to a common amortization schedule. For example, the first lines of an amortization schedule for a fixed rate mortgage of $ 250,000 over 30 years with an interest rate of 4.5% look like the table below.

Month Month 1 Month 2 Month 3
Full payment $ 1,266.71 $ 1,266.71 $ 1,266.71
Main $ 329.21 $ 330.45 $ 331.69
interest $ 937.50 $ 936.27 $ 935.03
Total interest $ 937.50 $ 1,873.77 $ 2,808.79
Loan balance $ 249,670.79 $ 249,340.34 $ 249,008.65

Note that the interest payment decreases from month to month, albeit slowly, while the principal payment increases slightly. The overall loan balance decreases. But the monthly payment of $ 1,461.53 remains the same.

Key points to remember

  • In a fixed rate payment, the total amount due remains the same for the duration of the loan, although the proportion that goes to interest and principal varies.
  • Fixed rate payment most often refers to mortgage loans. The borrower must choose between a fixed rate payment and a variable rate payment.
  • Banks generally offer a variety of fixed rate mortgages, each with a slightly different interest rate.

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