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Chapter 8. Fixed Rate Loans

┠What are the advantages and disadvantages of a fixed rate loan?

┠Why is the interest rate always a little higher for fixed rate loans?

┠What else should I know about fixed rate loans?

What are the advantages and disadvantages of a fixed rate loan?

There are three basic choices you will have when mortgaging your property — fixed, adjustable, or hybrid mortgages. There are variations of each.

The fixed interest rate mortgage (FIRM) is the traditional way to finance a home. At one time, it was the only mortgage offered by most lenders. It is also the easiest to understand because there are no changes over the life of the loan. A FIRM has a set rate of interest requiring an equal payment for a specific number of years. Future fluctuations of interest rates have no bearing on the loan.

Example: If you have a thirty-year loan at 7% interest with a $1,000 per month payment, that is it. You will pay $1,000 per month every month for thirty years. Your interest rate will always be 7%. Even if you make additional payments to reduce what you owe in order to pay the loan off sooner, your interest rate and payment amount will remain the same.

When interest rates are low and you expect to keep your property for many years, this is the best loan you can get.

Why is the interest rate always a little higher for fixed rate loans?

The problem with fixed rate loans is the lender's problem. Interest rates may increase over the years, but not for your loan. Because of this, lenders will structure your loan to protect themselves.

They will charge a higher rate of interest, and in many instances, higher fees than if you got a loan with an interest rate that would adjust (change) as market rates changed.

A way of reducing the higher rate is by using a buydown. By paying more discount points, you can get a lower interest rate.

Example: You have just sold your home and have $70,000 cash. The new home that you are going to buy only requires a $50,000 down payment. You do not trust yourself not to spend the other $20,000. You now have a choice. You can pay a larger down payment and reduce the amount that you borrow, reducing your monthly payment, or you could choose to buy down the interest rate to reduce your monthly payment.

Your decision will be based on how long you intend to pay on the loan. There are too many different possibilities to cover here. Ask your real estate agent or financial advisor to figure out which is best depending on your specific situation. As discussed, the most important factor is to be realistic as to how long you will keep the property.

There are other considerations besides the interest rate. The cost of the loan (points and fees) will also figure into the mathematical equation as to how many years it will take to make up the additional costs of the fixed rate loan.

The final consideration is the market. Looking at the market conditions for the latter part of 2007, you would have the following factors to consider.

When the first edition of this book was published, the outlook was for the latter part of 2004. I predicted that interest rates would rise, which they did. Now, however, the outlook is uncertain.

Oil prices continue to remain high, which creates both the potential for inflation and recession. Although the Federal Reserve Board has reduced interest rates multiple times, inflation could cause it to reverse course and raise them again.

If you believe rates will rise, you want the fixed rate loan. If you think high oil prices will lead to recession and rates will be stable or fall, the adjustable loan will save you money if you are correct.

Some lenders offer a mortgage that can be switched from adjustable to fixed as rates change. Ask your lender if this type of loan is offered.

There is an advantage to a fixed rate loan that does not show by just comparing numbers. A fixed rate loan gives you peace of mind. If rates go up, you are safe. If rates go down, you refinance. Unless you are fairly sure that you will not be in your home five years from now, you are usually better off getting the fixed rate loan.

Here is the problem: You plan to move in five years, so you get an adjustable rate loan. However, rates increase substantially. You now are ready to move up to your next home, which is bigger and more expensive. With the higher prevailing rates, you may no longer qualify or it may be just a bad time to get a new loan. The decision as to whether to get a fixed or adjustable loan gets harder.

There are not just adjustable loans, but combination or hybrid loans that are fixed for a period of years and then adjust as well. There are also adjustable loans that will rise or fall quickly and ones that will react much slower to rate changes. As these loans are discussed later, you will see that there are many factors to take into consideration when deciding between the different loan options.

What else should I know about fixed rate loans?

Most fixed rate loans are not assumable. They will contain a due on sale clause. This clause says that if you sell your property, you must pay off your loan. They may also contain a prepayment penalty. This protects the lender against falling interest rates, since you are most likely to pay off the loan by refinancing if rates drop dramatically.

An important question to ask about any loan is what happens if you make additional principal payments. An additional principal payment means that you pay more than the required amount of your monthly payment. This extra money reduces what you owe. It does not go to lessen the following month's payment. Since your interest amount is based on what you owe (your declining balance), you will pay less interest on future payments. Prepayment penalties can cover additional payments as well as paying off the loan in full. For example, this prevents you from quickly paying down your $200,000 loan to $50,000 and then making only the required payments.

Another question you should ask is how much extra you can pay each month. Before the use of computers, lenders required that you pay additional principal payments in specified increments, such as a double payment or $100 increments. Since the computer can figure out whether you paid $100 extra or $3.57 extra without difficulty, there is no longer a reason for mandated increments. If your lender requires specific increments, it will make additional payments more difficult for you.

Additional principal payments are especially important when rates are high. For example, on a $100,000, thirty-year loan with a rate of 8.5%, an additional principal payment of $25 per month would reduce the term from thirty years to twenty-six years, three months. An additional monthly payment of $75 would reduce it to just over twenty-one years, six months.

Even when rates are low, it helps. A $25 additional payment on a 5.5%, $100,000 loan would reduce the term to twenty-seven years. Additional principal payments are examined more closely in Chapter 12.

From the Expert

Be sure you know how much you can prepay without penalty, as well as the penalty you would owe for a complete payoff.

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