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Fixed-Rate Mortgage

Step-by-Step Guide to Understanding the Fixed-Rate Mortgage (FRM) Loan in Real Estate

Last Updated February 20, 2024

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Fixed-Rate Mortgage

How Does a Fixed-Rate Mortgage Work?

A fixed-rate mortgage is a loan where the charged interest rate remains constant over the entire borrowing term.

In real estate lending, a fixed-rate mortgage is a form of financing in which the interest rate is consistent over the borrowing term.

Since the interest rate remains unchanged over the term of the borrowing, there is far more consistency in the payments owed to the lender as part of the financing arrangement.

The borrowing term on a fixed-rate mortgage most often consists of 15, 20, and 30-year maturities.

The interest rate on a loan, or the cost of borrowing, is priced by lenders to reflect the riskiness of providing capital to a particular borrower.

From the perspective of a lender, the higher the perceived credit risk and the chance of the borrower defaulting on the loan, the higher the interest rate is set (and vice versa).

The monthly payment owed to the lender consists of the principal amortization and interest expense. The relationship between the principal and interest payment is that interest is charged on the outstanding principal of the loan.

Over the borrowing term, the proportion of principal in the total payment to the lender increases while the interest decreases. However, to reiterate, the interest rate charged on the loan remains fixed.

In the lending agreement, which states the contractual terms of the borrowing, the structure of the interest rate is most often either on a floating or fixed basis.

  • Floating Interest Rate → The interest rate pricing is variable and fluctuates based on changes in an underlying index (e.g., SOFR).
  • Fixed Interest Rate → The interest rate, as implied by the name, remains constant, irrespective of changes in the economic conditions and other external factors.

Therefore, the differentiating feature of a fixed-rate mortgage is the constant interest rate over the borrowing term, which offers more predictability in the monthly payment obligations for the borrower.

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Fixed-Rate Mortgage: What are the Pros and Cons?

The primary benefit of a fixed-rate mortgage is the predictability factor since the monthly interest and principal payments owed on a loan are consistent over the borrowing term.

Because the interest obligation is not tied to any underlying index, there is more stability attributable to the borrowing (i.e., no unexpected fluctuations in the monthly payments).

Therefore, the process of planning for the borrower is much easier because the interest expense burden and principal payments are pre-determined on the date of original issuance.

For instance, fixed-rate mortgages offer borrowers protection from the market interest rate rising.

On the other hand, the drawback to fixed-rate mortgages is that lenders tend to charge higher interest rates relative to other forms of financing.

Why? If the market interest rate were to rise, a lender would earn more on a loan priced at a floating interest rate.

But for a fixed-rate mortgage, the lender does not receive more interest (and a higher yield) in such market conditions.

  1. Rising Market Interest Rate → The borrower benefits since the interest rate on the loan is lower than the current market rate.
  2. Falling Market Interest Rate → The lender benefits because the interest rate on the loan is lower than the current market rate.

Furthermore, the initial monthly payments on fixed-rate mortgages tend to be higher in comparison to mortgages with variable pricing since interest is charged based on the outstanding principal balance.

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Fixed-Rate vs. Adjustable Rate Mortgage (ARM): What is the Difference?

The difference between a fixed-rate mortgage and an adjustable-rate mortgage is the interest rate pricing structure.

  • Fixed-Rate Mortgage → On a fixed-rate mortgage, the interest rate is set on the date of issuance and will remain constant until maturity. Regardless of changes in the economy and market interest rates, the initial interest rate remains stable over the borrowing term.
  • Adjustable Rate Mortgage (ARM) → In contrast, the interest rate on an adjustable-rate mortgage is variable and fluctuates based on an underlying market index to which the pricing is tied.

For an adjustable-rate mortgage, the increase or decrease in the market index can benefit the borrower or lender, which is a risk considered on both sides.

Therefore, ARMs could initially be priced at a lower interest rate, but fluctuations in the prevailing market conditions can cause that to change.

Fixed-Rate Mortgage Formula

The formula to calculate the monthly payment for a fixed-rate mortgage is as follows:

Monthly Payment = [P × r × (1 + r)^n] ÷ [(1 + r)^n 1]

Where:

  • P → Principal Loan Amount
  • r → Monthly Interest Rate (Annual Interest Rate ÷ 12)
  • n → Number of Payments (Borrowing Term in Years × 12)

Fixed-Rate Mortgage Calculator

We’ll now move on to a modeling exercise, which you can access by filling out the form below.

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30-Year Fixed-Rate Mortgage Calculation Example

Suppose we’re tasked with building a loan amortization schedule in Excel for a fixed-rate mortgage with the following financing terms:

Fixed-Rate Mortgage Loan Financing Assumptions:

  • Loan Amount = $800k
  • Borrowing Term = 35 Years
  • Annual Interest Rate (%) = 7.51%
  • Monthly Interest Rate (%) = 0.63%
  • Payment Frequency = 12.0x
  • Number of Periods = 420 Periods

Our first step is calculating the debt service, which equals the sum of the interest and principal amortization owed on the mortgage loan.

Using the PMT function in Excel, we can determine the periodic debt service payment as $5.4k.

=PMT (Monthly Interest Rate, Number of Periods, Loan Amount)

Given the fixed pricing structure of the mortgage loan, the loan constant remains the same until maturity.

The “Interest” and “Principal” columns in our loan amortization schedule in Excel are calculated for each month using the IPMT and PPMT Excel functions, respectively.

=IPMT (Monthly Interest Rate, Month Number, Number of Periods, Total Loan Amount)
=PPMT (Monthly Interest Rate, Month Number, Number of Periods, Total Loan Amount)

From the date of issuance to maturity, the interest component contributed a greater proportion of the debt service in the earlier periods.

However, that percentage gradually declines over time because the outstanding principal is reduced.

The remaining principal reaches zero at maturity, while the total principal amortization equals the original loan amount, confirming our loan schedule was built correctly.

Fixed-Rate Mortgage Calculator

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