What Is a Fixed-Rate Payment?
Let me explain what a fixed-rate payment is. It's an installment loan where the interest rate stays constant throughout the entire term of the loan. Your payment amount will remain the same every time, though the portions that go toward interest and principal will shift as you progress. Sometimes people call this a 'vanilla wafer' payment because it's straightforward and predictable, with no unexpected changes.
Key Takeaways
- In a fixed-rate payment, the total amount due stays the same throughout the loan's life, even as the interest and principal proportions vary.
- This term most often applies to mortgage loans, where you must choose between a fixed-rate payment and an adjustable-rate one.
- Banks typically provide several fixed-rate mortgage options, each with a slightly different interest rate.
How a Fixed-Rate Payment Works
You'll see fixed-rate payment agreements most commonly in mortgage loans. As a homebuyer, you generally have the option between fixed-rate mortgages and adjustable-rate mortgages, also known as ARMs or floating rate loans. You can decide which one suits your situation best.
A bank will usually offer various fixed-rate mortgage loans, each with its own interest rate. You might choose a 15-year term or a 30-year term. Lower rates are available for veterans and FHA loans, but remember that these often require you to buy extra mortgage insurance to guard against default.
Banks also provide adjustable-rate options. In the past, these could start with much lower interest rates than fixed ones. When rates were low overall, you could get an even better introductory rate on an ARM, easing your payments right after buying. Once that intro period ends, the rate and payments could rise if overall rates increase. But when rates were high, banks might push fixed-rate loans with intro breaks, expecting rates to drop later.
Since the 2008 housing crisis, with mortgage rates staying below 5%, the difference between fixed and adjustable rates has narrowed significantly. As of August 13, 2020, the average 30-year fixed mortgage rate was 2.96%, while a comparable ARM was at 2.9%. That ARM is a 5/1 type, meaning the rate is fixed for five years and can adjust upward each year after that. The gap is just 0.06% between the average 30-year fixed and adjustable rates.
Special Considerations
With a fixed-rate payment loan, your monthly amount doesn't change, but the breakdown between principal and interest does shift each month. Early on, most of your payment covers interest, with less going to principal. Over time, as you pay down the loan through amortization, the interest portion decreases, and more goes to principal.
Example of a Fixed-Rate Payment Loan
In the home loan world, fixed-rate payments follow a standard amortization schedule. Take a $250,000, 30-year fixed-rate mortgage at 4.5% interest as an example. The first few months of the schedule show how it works.
Example of a Loan Amortization Schedule
- Month One: Total Payment $1,266.71, Principal $329.21, Interest $937.50, Total Interest $937.50, Loan Balance $249,670.79
- Month Two: Total Payment $1,266.71, Principal $330.45, Interest $936.27, Total Interest $1,873.77, Loan Balance $249,340.34
- Month Three: Total Payment $1,266.71, Principal $331.69, Interest $935.03, Total Interest $2,808.79, Loan Balance $249,008.65
You can see that the interest drops slightly each month, the principal rises a bit, and the balance decreases, but your total payment stays fixed at $1,266.71.
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