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Mortgage Basics

What Is a Fixed-Rate Mortgage?

A fixed-rate mortgage is a home loan on which the interest rate remains constant over the life of the loan and is the most popular form of mortgage in the U.S.

In contrast to adjustable-rate mortgages (ARMs), for which monthly payments typically change after an introductory period of several years, fixed-rate mortgages are more stable and predictable.

The introductory interest rates (and monthly payments) on ARMs may be lower than those on comparable fixed-rate mortgages, but their potential for rate- and payment increases over time mean ARMs can be more expensive over the lifetime of a loan than similar fixed-rate mortgages.

What to Look for in a Fixed-Rate Mortgage

There are three basic factors that deserve consideration when you are shopping for a fixed-rate mortgage:

Loan Amount

The loan amount, or principal, is the sum of money you are borrowing. Ideally, this will represent 80% or less of the cost of the home you plan to buy, reflecting your ability to make a cash down payment of at least 20% on the purchase.

If you cannot make a 20% down payment, you can apply for a Federal Housing Administration mortgage. But if you don't qualify, you will likely need to purchase private mortgage insurance, which will increase your monthly payment.

Payback Period

The duration on a mortgage can be any number of months, as negotiated by borrower and lender, but the most popular mortgage options are 15 years (180 months) and 30 years (360 months).

The main practical difference between 15-year and 30-year mortgages is that, on loans with equal principal and fees, the monthly payments on a 30-year loan will be considerably smaller than those on the 15-year loan. But because interest is paid over a period twice as long, the total cost of the loan is considerably higher.

Interest Rate

The interest rate is essentially the cost of the loan, and it's the main metric you should look for when comparing loans for similar amounts and payback periods.

There are two interrelated metrics to keep in mind when comparing the costs of mortgage loans, annual interest rate and annual percentage rate (APR). Both are expressed as percentages, and both are useful for comparing and calculating the costs of loans. They are not interchangeable, however, so take care to stick to apples-to-apples comparisons.

The interest rate is essentially the price of the loan. The lower the rate, the less the loan will cost you over time. The APR combines the annual interest rate with other additional fees and expenses that will be included in your monthly payment, and it more closely reflects what you'll actually pay for the loan.

Federal regulations require mortgage lenders to include an estimated APR with each loan offer. Once you apply for a loan on a specific property, the lender is required to refine that estimate to reflect costs such as property taxes and homeowner association fees that may be included.

Other Potential Mortgage Costs and Considerations

Fees and other expenses may apply to your mortgage. Often, these are rolled into the loan amount and paid in installments that are added to the monthly payment amount. Such fees largely account for the difference between the annual interest rate and the APR.

In addition to private mortgage insurance, property taxes, and homeowners' association fees, these may include:

Origination Fees

Lenders sometimes charge a service fee for issuing a loan. The amount is a percentage (or partial percentage) of the loan principal. In some cases, this amount must be paid in full at the time of purchase, rather than incorporated into the loan amount.

Discount Points

To save interest costs over the lifetime of a mortgage loan, borrowers sometimes "buy down" the interest rate on their loans by increasing the amount of cash they put down at the time of purchase. An additional payment equal to 1% of the principal is known as a point. Depending on the loan terms, each additional point paid might reduce the annual interest rate by 0.5% or 0.25%.

This strategy can lead to significant savings over the lifetime of a mortgage, but it may not make sense for homeowners who plan to sell their homes before their mortgages are paid in full. It takes years for interest savings to recoup the amount spent in points, and if you plan to sell before that "break-even" point, discount points may not be worth the cost.

Discount points can sometimes be rolled into the loan financing and spread out over the lifetime of the loan, increasing your monthly payments, but it's more common for lenders to require them to be paid up-front.

Principal and Interest

In addition to the loan costs, of course, you'll pay back a portion of the principal each month. While your monthly payment amount stays constant over the lifespan of the loan, the portion of those payments that go toward principal shifts over time, according to a formula known as an amortization schedule.

In the first year of the loan's life, 75% or more of each monthly payment might go toward interest, with the remaining fraction paying back principal (and securing your equity in your property). Over time, the proportions shift. The fraction of each payment that pays down principal increases a little each month and the interest-payment fraction diminishes so that by the last year of the loan term, payments consist almost entirely of principal payments.

What Determines Interest Rates?

The interest rate a lender offers any given borrower is determined by a number of factors. Rates rise and fall with market conditions, such as the discount rate set by the Federal Reserve Board of Governors.

Following a period of extraordinarily low interest rates that began before the financial crisis of 2007-08, the Fed began gradually increasing the discount rate in late 2015. Mortgage rates have climbed somewhat as a result, and additional increases are likely, but mortgage rates are still relatively low by historical standards.

Impact of Credit History on Mortgage Costs

Lenders also exercise some discretion (within regulated limits) to charge you interest based on their evaluation of your financial situation and credit history. Lenders typically offer their lowest mortgage rates to borrowers with strong credit, as reflected in strong credit scores and relatively unblemished credit reports, as well as metrics including income, total debt, and financial assets.

Applicants with low credit scores and/or credit histories that include major negative events such as foreclosures or bankruptcies, may have to consider subprime mortgages as an option. Some may have difficulty gaining approval for any mortgage.

To get an idea of the impact credit scores can have on mortgage interest in your state, check U.S. Consumer Finance Protection Bureau (CFPB) interactive mortgage calculator. And here you'll find some helpful tips for sprucing up your credit score before you seek a mortgage loan.

Fixed-rate mortgages are tried-and-true vehicles for helping Americans become homeowners. They constitute 90% of all mortgage applications nationwide, and one could be right for you.

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