Jack M. Guttentag The Mortgage Professor

A reader writes: Your web site contains 36 articles on adjustable rate mortgages (ARMs), which account for about 25% of the market, and no articles on fixed-rate mortgages (FRMs), which account for the other 75%. Isn't this a little unbalanced?

Ouch. You're right! My only excuse is that ARMs are more complicated and borrowers need more help with them, but that doesn't justify a score of 36 to nothing. This article is a small gesture of atonement.

What Is an FRM? Fixed Rate vs. 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. For example, if the loan was for $300,000 at 6% and the term was 300 months, then the payment in the first month would be $1,000 of principal plus $1,500 of interest for a total of $2,500.

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 U.S. is called a "graduated payment mortgage," or GPM. They appeared in the early '80s and are still available from a few lenders.

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.

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 $1,798.66. 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 $1,798.66 figure come from? It's calculated from an algebraic formula that you can see here. A much easier way to work the calculation is use a financial calculator such as Hewlett-Packard's HP19B, or an online calculator like this one. Technophobes can buy a book of monthly payments at a bookstore.

Rising Principal Payments Over Time

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

This feature, where borrowers make the same payment every month but the saving component of the payment also increases every month, is powerful but underappreciated. Some borrowers don’t recognize that debt repayment is saving, and many of those who do think they aren’t earning any return on it. I'm frequently asked whether they wouldn't 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, 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 terms apply almost entirely to FRMs.