Fixed Rate Mortgages (FRMs)
May 8, 2006, Revised November 14, 2008, Reviewed February 6, 2011

"Your web site contains 36 articles on adjustable rate mortgages (ARMs), which account for about 25% of the market, and zero articles on fixed-rate mortgages (FRMs), which account for the other 75%. Is this not a little unbalanced?"

Ouch, you are right. My only excuse is that ARMs are more complicated and borrowers need more help with them, but that does not justify a score of 36 to nothing. This article is a small gesture of atonement.

What Is An FRM? Fixed Rate Versus Fixed Payment


An FRM is a mortgage that has no provision for changing the interest rate. Hence, the rate stated in the note is fixed for the entire term of the loan.

Usually, the term "FRM" also means that the payment is fixed for the life of the loan and pays it off over the term. This should be (but usually isn’t) called a "level-payment fully amortizing FRM" to distinguish it from other types of loans that have a fixed rate but not a fixed payment.

For example, one of the earliest types of fixed-rate mortgages was repaid with equal monthly payments of principal, plus interest. If the loan was for $300,000 at 6% and the term was 300 months, then the payment in month 1 would be $1,000 of principal plus $1500 of interest for a total $2500. Each month the total payment would decline because interest would be calculated on a lower balance. This was the standard type of mortgage in New Zealand for many years, despite the obvious disadvantage of high payments in the early years.

A fixed-rate mortgage can also have a rising payment. The version in the US is called a "graduated payment mortgage", or GPM. They appeared in the early 80s and are still available from a few lenders. See Graduated Payment Mortgages.

The interest-only version of a fixed-rate mortgage also does not have fixed payments. Borrowers begin paying only the interest, which declines if they voluntarily pay any principal, until the end of the interest-only period. At that point, the payment jumps and it becomes a level-payment fully amortizing FRM. See Interest Only Mortgages.

By prevailing practice, the term "FRM" without any modifiers means a mortgage with a fixed rate and level payments that fully pay off the balance. For example, on a $300,000 30-year 6% FRM, the monthly payment is $1798.66. If the borrower makes that payment every month for 30 years, the 360th payment will reduce the balance to zero.

Calculating the Fully Amortizing Payment


Where does that $1798.66 figure come from? It is calculated from an algebraic formula, those interested can find it in Formulas. The much easier way is use a financial calculator, such as an HP19B, or an on-line calculator such as my Monthly Payment Calculator: Fixed-Rate Mortgages. Technophobes can buy a book of monthly payments at a book store.

Rising Principal Payments Over Time


On an FRM, the composition of the payment between principal and interest changes every month. At the beginning, it is mostly interest but the principal portion gradually rises over time. In the example, the principal payment in month 1 is $299, in month 12 it is $316, and in month 60 it is $401.

This feature, where borrowers make the same payment every month but the saving component of the payment increases every month, is powerful but underappreciated. Some borrowers don’t recognize that debt repayment is saving, and many of those that do think they aren’t earning any return on it. I am frequently asked whether they would not do better putting their money in a bank account earning 3% than repaying their mortgage.

In fact, a principal payment of $100 on a 6% mortgage earns the same return as a $100 bank deposit that pays 6%. The deposit earns $6 a year in interest while the principal payment reduces interest payments by $6 a year. The effect on the borrower’s wealth is the same.

Of course, if you can earn 10% on your money, paying down a 6% mortgage is not the best choice. The recent popularity of interest-only loans, and option ARMs that allow borrowers to pay less than the interest, has been encouraged by the notion that borrowers can earn a return higher than the mortgage rate by investing their money elsewhere. In my view, however, most borrowers cannot earn a return above the mortgage rate without taking unacceptable risk.

Different Terms on FRMs


FRMs come with different terms, ranging generally from 10 years to 40 years, with the 15 and 30-year being the most popular. (In contrast, ARMs are almost all 30 years.) This means that my articles on Mortgage Term apply almost entirely to FRMs.
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