Fixed Rate Mortgages

Fixed rate mortgages usually have a term of thirty (30) or fifteen (15) years.  Throughout the entire term of the mortgage, the interest rate charged will be fixed and will not vary.  Also, each monthly loan repayment will be the same dollar amount throughout the term of the loan.  As we have noted earlier, a loan repayment has two (2) component parts: principal repayment and payment of interest for borrowed principal not yet repaid.  Therefore, in the earlier years of the loan when the outstanding borrowed principal is greatest most of your monthly mortgage payment will be interest expense (which is deductible for income tax purposes as an Itemized Deduction – see page 16) and very little of the monthly mortgage payment will be nondeductible principal.  Conversely, in the later years of the mortgage, when most of the principal on the loan has been repaid, much less of the monthly mortgage payment will constitute interest and more will be principal.  Restudy the Example in the Tax Planning section of the book on page 16 that illustrates this phenomenon with regard to a fixed rate mortgage.

The fixed rate mortgage just described has traditionally been the preferred choice for home mortgages for a couple of reasons.  The big reason is that the monthly mortgage expense will never vary over the term of the loan.  The monthly mortgage amount can be locked in because the interest expense charged on the loan will never vary.  Thus, from a budgeting standpoint, the fixed rate loan is great as we're locking in our monthly mortgage expense over the long-term.

What are the downsides to the fixed rate mortgage?  As we also just noted, because the interest expense is fixed, the mortgage lender will charge a higher rate of interest to compensate it for the risk that market rates of interest will go up in the future.  If, in fact, market rates of interest do significantly rise in the future, the homeowner who financed the purchase of his or her home with a fixed rate mortgage looks like a genius. Historically speaking, this situation was generally the case in the 1970's and early 1980's when inflation was fairly pronounced.

Example:  Mark and Debbie take out a 30-year mortgage to finance the purchase of their home.  The principal amount borrowed from the Bank is $100,000 and the rate of interest is fixed at 7% over the life of the mortgage.  The monthly payments will always be $665.  Although $100,000 was borrowed, approximately $239,400 ($665 times 12 months times 30 years) will be repaid to the Bank.  This amount comprises the total of $100,000 of principal repaid to the Bank and $139,400 of interest paid to the Bank over the life of the mortgage.

Two years later, the market rate of interest on a comparable loan has risen to 10%.  Another couple, John and Kelly, take out a 30 year mortgage to finance the purchase of their home.  As with Mark and Debbie, the principal amount borrowed from the Bank is $100,000 but the rate of interest is now fixed at 10% over the life of the mortgage.  John and Kelly's monthly payments will always be $878.  Their total payments over 30 years will be slightly more than $316,000 with about $216,000 of total interest payments.

The Bank would like to get rid of Mark and Debbie's mortgage at this point in time because market rates of interest have gone up, but Mark and Debbie are more than happy to sit tight with their 7% mortgage loan.  There will be no reason for Mark and Debbie to consider refinancing their existing mortgage as they enjoy a locked-in rate that is significantly lower than current market rates of interest.

If market rates of interest are trending downward (as generally has been the case since the early 1980's) the homeowner who took out a fixed rate home mortgage might wish that he or she hadn't and may be compelled to refinance the home with a new lower rate mortgage (and a new round of closing costs).

Example:  Mark and Debbie in the prior Example take out the $100,000, 7% mortgage loan that was noted.  Five years later, market rates of interest have declined from 7% to 5% on comparable loans.  If Mark and Debbie refinance their mortgage at 5% for a term of 25 years, they would find their monthly payments reducing from $665 per month to $585 per month, a savings of $80 per month or over $960 per year.  The couple has a significant incentive to refinance the old loan.  If they do so, the Bank on the original mortgage loan loses one of its more profitable mortgage loans.

You might think that this sword cuts both ways.  For example, if the homeowner takes out a fixed rate mortgage and market interest rates go down in the future, won't Banks make out since the fixed rate mortgage is charging a mortgage expense in excess of what is then a market rate of interest?  Yes, if the homeowner maintains that high rate mortgage and doesn't refinance, which is what he or she will almost always do as illustrated in the prior Example.