Fixed-Rate Payment Definition – Loan Basics
What Is a Fixed-Rate Payment?
A fixed-rate payment is an installment loan with an interest rate that cannot vary during the life of the loan. The payment amount also will remain the same, though the proportion that goes to interest and principal may vary.
A fixed-rate payment is sometimes referred to as a vanilla wafer payment, presumably because it contains no surprises.
How a Fixed-Rate Payment Works
The fixed-rate payment is most often used in mortgage loans. Homebuyers generally have a choice of fixed-rate or adjustable-rate (ARM) mortgage loans. The adjustable rate is also known as a floating rate. The homebuyer has to decide which is the betterÂ choice.
A bank will generally offer a variety of fixed-rate payment mortgage loans, each with a slightly different interest rate. Typically, a homebuyer can choose a 15-year term or a 30-year term. Slightly lower rates are offered for veterans and for Federal Housing Authority (FHA) loans, which include insurance against default.
There also will be options for adjustable-rate loans. Historically, these could have a substantially lower or higher starting rate than fixed-rate payment loans. In times when interest rates were low, the new home buyer could get an even lower introductory rate on an adjustable-rate mortgage. That meant a break on the payments in the months immediately after the purchase, while the bank had the ability to raise the rate and the payments as interest rates overall rose. When interest rates were high, the bank was inclined to offer the break on the fixed-rate loans, as it anticipated that rates on new loans would go lower.
However, with mortgage rates hovering below five percent since the 2008 housing crisis, the gap between fixed-rate and variable-rate loans has practically closed. As of April 2019, the average interest rate nationwide on a 30-year fixed mortgage was 4.03%, according to bankrate.com. The rate for a comparable adjustable-rate loan was 4.02%. The latter is a so-called "5/1 ARM," meaning the rate remains fixed for at least five years and then may be adjusted upwards annually thereafter.
The amount paid for a fixed-rate payment loan remains the same month after month, but the proportion of principal and interest changes every month. The earliest payments are made up of more interest than principal. Month by month, the amount of interest paid declines gradually while the principal paid increases. This is called loan amortization.
The term is used in the home loan industry to refer to payments under a fixed-rate mortgage which are indexed on a common amortization chart. For example, the first few lines of an amortization schedule for a $250,000, 30-year fixed-rate mortgage with a 4.5% interest rate looks like the table below.
|Month||Month 1||Month 2||Month 3|
Note that the interest payment goes down from month to month, albeit slowly, while the principal payment increases slightly. The overall loan balance goes down. But the monthly payment of $1,461.53 remains the same.
- In a fixed-rate payment, the total amount due remains the same throughout the life of the loan, although the proportion that goes to interest and principal varies.
- The fixed-rate payment most often refers to mortgage loans. The borrower must decide between a fixed-rate payment and an adjustable-rate payment.
- Banks generally offer a variety of fixed-rate payment mortgage loans, each with a slightly different interest rate.