Conventional Fixed-Rate Mortgage – Definition

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Conventional Fixed Rate Mortgage Definition

A fixed-rate mortgage is a type of mortgage loan whose interest rate does not change throughout the loan duration. The duration that is common for most fixed-rate mortgage is 15 years or 30 years.

A fixed-rate mortgage can either be a conventional loan or a loan secured by the Federal Housing Authority, Fannie Mae or Freddie Mac.  For a conventional mortgage, the loan duration is 30 years and there is a fixed interest rate for these years.

A Little More on What is a Fixed-Rate Mortgage  

There are different types of loan that lenders can offer, a fixed-rate mortgage loan is one of them. When a fixed-rate mortgage loan has a fixed monthly installment payments, it is an amortized loan, this is the most common type. In a fixed-mortgage loan, both the lenders and borrowers have varying responsibilities and risks they incur.

The interest rate is the major risk in a fixed-rate mortgage loan given that the interest rate might either rise or fall. When the interest rates rises, the borrower incurs lower risk while the lender incurs higher risk. When the interest rate falls also, the borrower faces a higher risk while the lender faces a lower risk.

Amortized Fixed-Rate Mortgage Loans

The most common type of fixed-rate mortgage is the amortized fixed-rate mortgage. It features a fixed interest rate during the life span of the loan and monthly installment payments. When offered by a lender, this type of loan has an amortization schedule often created when the loan is issued.

In a fixed-rate mortgage, all installment payments have the same fixed interest rate, this lasts throughout the entire loan period. Furthermore, in this type of loan, at the loan draws nearest to its maturity period, the borrower pays less interest but more principal.

Adjustable Rate Mortgages

Aside from fixed-rate mortgage, lenders can also offer variable or adjustable rate mortgage loans. An adjustable rate mortgage is also issued as an amortized loan with an installment payment plan throughout the loan duration.

Borrowers of adjustable rate mortgage enter the loan agreement with the hope that interest rates will decline in the future time, when interest rates fall, the interest payable will also decrease. Adjustable rate mortgage are amortized loans that have fixed – rates interest for the first few years before the interest rate becomes variable, unlike fixed-rate loans that have unchanging interest rates all through the loan period.

Non-Amortizing Loans

Generally, lenders issue fixed-rate mortgages as either amortized loans or non-amortized loans. Lenders structure mortgages given certain considerations and the terms of the loan agreement. A non-amortizing loan is commonly called an interest-only loan whereby borrowers are charged annual deferred interest. This type of mortgage is also a balloon payment loan because lenders require borrowers to make a lump sum balloon payment and thereafter pay interests only based on the loan schedule.

References for Conventional Fixed Rate Mortgage

Academic Research on Conventional Fixed Rate Mortgage

The impact of the agencies on conventional fixedrate mortgage yields, Hendershott, P. H., & Shilling, J. D. (1989). The impact of the agencies on conventional fixed-rate mortgage yields. The Journal of Real Estate Finance and Economics, 2(2), 101-115. Between the early 1980s and 1986, the share of new conforming (under $153,000 in 1986) conventional fixed-rate mortgages (FRMs) that went into Fannie Mae and Freddie Mac mortgage pools increased from under 5% to over 50%. The impact of these agencies moving from negligible participants to dominant players in this market is investigated in this study by an analysis of yields on 4,900 loans closed in California during May–June 1978 and 1,800 closed in May–June 1986.

A generalized valuation model for fixedrate residential mortgages, Kau, J. B., Keenan, D. C., Muller, W. J., & Epperson, J. F. (1992). A generalized valuation model for fixed-rate residential mortgages. Journal of money, credit and banking, 24(3), 279-299. This paper uses option pricing techniques to rationally price mortgage instruments subject to both default and prepayment risk. Attention is given to terminations due to purely financial consideration of the mortgage contract itself, as well as to personally induced terminations. Explicit inclusion of default in the mortgage valuation procedure also permits the valuation of insurance against such default. Qualitatively, it is found that default differs significantly in the behavior from either prepayment or nonfinancial termination. Quantitatively, however, there is significant substitution between prepayment and default, so that the addition of a default feature to the contract has only a modest impact on mortgage values, unless there is substantial price volatility in the housing market or a high loan-to-value ratio. Copyright 1992 by Ohio State University Press.

Modeling conventional residential mortgage refinancings, Giliberto, S. M., & Thibodeau, T. G. (1989). Modeling conventional residential mortgage refinancings. The Journal of Real Estate Finance and Economics, 2(4), 285-299. This article models fixed-rate mortgage refinancings and offers an empirical test of the model. The model relates the probability that a household prepays its residential mortgage to both financial and economic variables. The financial variables included in the model measure the value of the embedded call option present in conventional fixed-rate mortgage loans. The economic variables measure the household’s propensity to prepay for housing consumption adjustment reasons. Our main empirical finding is that increased interst-rate volatility significantly decreases prepayment probability. In addition, we find some statistical evidence to support the hypothesis that prepayment rates increase with increases in household income, increases in household size, and vary by age of household head and regionally.

A dynamic analysis of fixed-and adjustable-rate mortgage terminations, Calhoun, C. A., & Deng, Y. (2002). A dynamic analysis of fixed-and adjustable-rate mortgage terminations. In New Directions in Real Estate Finance and Investment (pp. 9-33). Springer, Boston, MA. This paper provides a side-by-side comparison of loan-level statistical models for fixed- and adjustable-rate mortgages. Multinomial logit models for quarterly conditional probabilities of default and prepayment are estimated. We find that the estimated impacts of embedded option values for prepayment and default are generally quite similar across both FRM and ARM loans, providing additional empirical support for the basic predictions of the options theory. We also find that differences in estimates of conditional probabilities of prepayment and default associated with mortgage age, origination period, original LTV, and relative loan size, indicate the continued significance of these other economic and demographic factors for empirical models of mortgage terminations.

Adjustable and fixed rate mortgage termination, option values and local market conditions: An empirical analysis, VanderHoff, J. (1996). Adjustable and fixed rate mortgage termination, option values and local market conditions: An empirical analysis. Real Estate Economics, 24(3), 379-406. This paper analyzes the probabilities of prepayment or default for Fixed Rate Mortgages (FRMs) and Adjustable Rate Mortgages (ARMs). Using data from the period 1985–1992, the analysis indicates that the likelihood of prepayment of thirty year FRMs was determined primarily by house price appreciation and personal income growth and the likelihood of prepayment of fifteen year FRMs was determined primarily by interest rate changes. ARMs were prepaid less frequently than FRMs, were less likely to be prepaid when interest rates declined and defaulted more often than FRMs. The analysis provides evidence that ARM holders are less mobile than FRM holders.

A note on hybrid mortgages, Ambrose, B. W., LaCourLittle, M., & Huszar, Z. R. (2005). A note on hybrid mortgages. Real Estate Economics, 33(4), 765-782. We extend the work of Ambrose and LaCour-Little (2001) on traditional one-year adjustable rate mortgages by analyzing the performance of 3/27 hybrid instruments. Under this contract innovation, which first appeared in the mid-1990s, note rates are fixed for three years after which they convert to a traditional one-year adjustment schedule. We find high rates of prepayment, particularly at time of initial rate adjustment, and relatively high rates of default, as would be consistent with the payment shock that often affects adjustable rate loans.

Integration of mortgage and capital markets and the accumulation of residential capital, Hendershott, P. H., & Order, R. V. (1989). Integration of mortgage and capital markets and the accumulation of residential capital.

The conditional probability of foreclosure: An empirical analysis of conventional mortgage loan defaults, Phillips, R. A., & VanderHoff, J. H. (2004). The conditional probability of foreclosure: An empirical analysis of conventional mortgage loan defaults. Real Estate Economics, 32(4), 571-587. This paper analyzes the factors affecting the conditional probability that defaulted residential mortgage loans will foreclose. We analyze a large national sample of conventional loans, which have been in default at least once during the 1988 to 1994 period. For such loans, lenders and borrowers either individually or jointly make choices which lead to the following outcomes: (1) resumption of payments, (2) termination by prepayment, or (3) foreclosure. Our estimates of a logit model indicate that termination option values and local area economic and housing market conditions affect default resolution probabilities. Perhaps more importantly, simulations using the logit model indicate that the efficiency of the default resolution process may be substantially improved by legal and regulatory reforms.

Adjustable-versus fixedrate mortgage choice: The role of initial rate discounts, Richard, P., & James, V. (1991). Adjustable-versus fixed-rate mortgage choice: The role of initial rate discounts. Journal of Real Estate Research, 6(1), 39-51. This paper investigates relative pricing determinants of the fixed-rate mortgage (FRM) versus adjustable-rate mortgage (ARM) decision. A probit model is estimated using data from a national sample of residential housing transactions for the 1986 to 1988 period. The results suggest that the probability of ARM choice is highly sensitive to ARM initial rate (“teaser”) discounts and differences in the ratio of FRM to ARM points. In addition, the findings indicate that the level of local housing prices is an important determinant of ARM choice.

Option theory and floating-rate securities with a comparison of adjustable-and fixedrate mortgages, Kau, J. B., Keenan, D. C., Muller III, W. J., & Epperson, J. F. (1993). Option theory and floating-rate securities with a comparison of adjustable-and fixed-rate mortgages. Journal of business, 595-618. This article demonstrates how to value floating-rate securities, in particular adjustable-rate mortgages (ARMs), in the presence of default. The problem is not a straightforward one since endogenous termination (default and prepayment) necessitates solution by backward procedures, but caps on the floating rate then create path dependencies. The solution is to introduce an artificial state variable, the past contract rate, in addition to the natural stochastic variables, the interest and the house price process. With this technique, a numerical investigation of the properties of defaultable ARMs is provided. In all cases, a comparison is made with standard fixed-rate mortgages.

The American mortgage in historical and international context, Green, R. K., & Wachter, S. M. (2005). The American mortgage in historical and international context. Journal of Economic Perspectives, 19(4), 93-114. The U.S. mortgage before the 1930s would be nearly unrecognizable today: it featured variable interest rates, high down payments and short maturities. The authors compare the form of U.S. home mortgages today with those in other countries. The U.S. mortgage provides many more options to borrowers than are commonly provided elsewhere: American homebuyers can choose whether to pay a fixed or floating rate of interest; they can lock in their interest rate in between the time they apply for the mortgage and the time they purchase their house; they can choose the time at which the mortgage rate resets; they can choose the term and the amortization period; they can prepay freely; and they can generally borrow against home equity freely. They can also obtain home mortgages at attractive terms with very low down payments. The authors discuss the nature of the U.S. government intervention in home mortgage markets that has led to the specific choices available to American homebuyers. They believe that the unique characteristics of the U.S. mortgage provide substantial benefits for American homeowners and the overall stability of the economy.

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