Deciding it’s time to buy a house is a big step for any individual or family, so from our family at Solarity to yours: congratulations! With any exciting adventure can come uncertainty, however, and we’re sure that you’ve been looking at enough mortgage information to make your head spin. Our experts at Solarity Credit Union want to make sure you understand all your options, so let’s go through some of the most popular features of fixed-rate home loans. Which fixed-rate home loan is right for you?
What are “fixed-rate home loans”?
In the world of home loans, there are, broadly speaking, two types of mortgages: fixed-rate and adjustable-rate mortgages (ARMs), sometimes called variable-rate mortgages. The difference between them is right in the name. Fixed-rate mortgages have the same interest rate from beginning to end, while adjustable-rate mortgages have an interest rate that fluctuates over time.
With a fixed-rate loan, your interest rate is set from the moment of your closing. It won’t change unless you refinance.
On the other hand, ARMs tend to start with a very low fixed rate for a given period (a couple of years or so), and then the “adjustable” part kicks in. ARMs don’t fluctuate on the whim of your lending institution, though. They’re almost always tied to a given economic index, such as the Federal Prime Rate.
Sometimes, this can be to your benefit as a homeowner. If the index your lender uses decreases, so does your monthly mortgage payment and the amount of interest charged on your loan each year. But let’s not forget: what goes down can also come up. If you obtain an ARM when interest rates are low but then the index goes up, you will end up paying more.
Not only can you end up with higher payments, but continued fluctuation can also make it nearly impossible to maintain a financial plan. For this reason, fixed-rate home loans are usually more popular. When you know exactly how much you’ll be paying every month, it’s much easier to plan for the future, develop a budget and keep to it. There are enough unforeseen expenses in daily life, but your mortgage doesn’t have to be one of them.
So, does a fixed-rate home loan sound like what you’re looking for? Let’s look at some of the options when you choose a fixed interest rate.
Choose the term of the loan
With a fixed-rate home loan, you get to decide over how many years you repay the money. The most common terms are 15 and 30 years, but you might also find 10-, 20- and even 45-year terms. This sounds pretty straightforward, but when you add interest and compound it over the term of the loan, it gets more complicated.
As Albert Einstein once said, compound interest is the most powerful force in the universe. And it needs one thing to really add up: time.
Let’s break it down.
How does interest accumulate?
In any mortgage, there are two amounts you need to account for: the principal is the amount of money you borrow (the value of the home minus your down payment), and interest is the amount you pay for the benefit of borrowing the principal. This amount varies depending on your interest rate.
Usually, in the US and Canada, interest is calculated (or compounded) twice a year. That means a mortgage rate will usually be slightly higher on an annual basis than the number suggests. A 6% fixed-rate home loan compounded semiannually will result in a yearly increase of around 6.9%, for instance. The longer you take to pay off your home loan, in other words, the more times the interest is compounded—and the more you pay in the end.
In other words, there is an inversely proportional relationship between the length of a mortgage term and the total amount you will pay. For two mortgages with the exact same principal and the exact same interest rate, the shorter one will have higher monthly payments but a lower final cost, while the longer one will have lower monthly payments but a higher final cost.
Let’s compare some actual numbers. You can use a mortgage calculator that lets you enter different interest rates, like the one found at Calculator Soup, to see it in action.
Let’s say we have three families, all of whom get identical mortgages: a $300,000 home with a 3.5% interest rate. One family gets a 15-year mortgage, the second gets a 30-year mortgage and the third gets a 45-year mortgage.
- Family 1: (15-year fixed-rate loan) pays $2,145 a month, for a final price of $386,100
- Family 2: (30-year fixed-rate loan) pays $1,347 a month, for a final price of $484,920
- Family 3: (45-year fixed-rate loan) pays $1,104 a month, for a final price of $596,160
Family 3 pays $1,000 less on their mortgage every month than family 1 does, but winds up paying over $200,000 more over the course of their fixed-rate home loan.
Since interest rates can change daily and lending institutions can offer different rates for different loan terms, when you’re ready to buy, you’ll also want to crunch numbers with a calculator that uses real-time rates, such as Solarity's payment calculator. This personalized information can help you make the right decision.
So which type of fixed-rate home loan is better?
At the end of the day, it depends on your finances and your situation. Which is more valuable to you: total money in your pocket over decades or monthly income? An extra $1,000 to do with as you please every month—including making upgrades to your home—is quite a lot of money. On the other hand, so is $200,000 over most of your life—and the 15-year mortgage holder owns their home much more quickly so they can stop making payments sooner.To start considering your options, talk to a mortgage expert at Solarity Credit Union. Our Home Loan Guides are waiting to discuss your personal needs and hopes for the future. We'll help you choose the best fixed-rate home loan for your lifestyle and budget.