Q: Your Web site contains 36 articles on adjustable-rate mortgages (ARMs), which account for about 25 percent of the market, and zero articles on fixed-rate mortgages (FRMs), which account for the other 75 percent. Is this not a little unbalanced?
A: Ouch, you are right. My only excuse is that ARMs are more complicated and borrowers need more help with them, but that does not justify a score of 36 to nothing. This article is a small gesture of atonement.
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 percent and the term was 300 months, then the payment in Month One would be $1,000 of principal plus $1,500 of interest for a total $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 United States 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 percent FRM, the monthly payment is $1,799. If the borrower makes that payment every month for 30 years, the 360th payment will reduce the balance to zero.
Where does that $1,799 figure come from? It is calculated from an algebraic formula (those interested can find it on my Web site: Look in the “Table of Contents” under “Formulas”). The much easier way is use a financial calculator, such as an HP19B, or an online calculator such as my number 7a. Technophobes can buy a book of monthly payments at a bookstore.
On an FRM, the composition of the payment between principal and interest changes every month. At the beginning, it is mostly interest, but the principal portion gradually rises over time. In the example, the principal payment in Month One is $299; in Month 12 it is $316; and in Month 60 it is $401.
This feature, where borrowers make the same payment every month but the saving component of the payment increases every month, is powerful but underappreciated. Some borrowers don’t recognize that debt repayment is saving, while many of those who do think that they aren’t earning any return on it. I am frequently asked whether they would not do better putting their money in a bank account earning 3 percent than repaying their mortgage.
In fact, a principal payment of $100 on a 6 percent mortgage earns the same return as a $100 bank deposit that pays 6 percent. 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 percent on your money, paying down a 6 percent 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.
The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.