Fixed Rate vs Variable Rate Mortgages: A Closer Look
Picture this: you’re gearing up to buy a new home and you’re going through a checklist of things you have to do before and after the home becomes yours. Near the top of the list, written in big, red letters is “Get a mortgage.”
You proceed to do some research on the different type of mortgage products available are immediately overwhelmed by what you find. Several questions are swirling around in your mind, and chief among them are “What’s the difference between a fixed-rate and a variable-rate mortgage?” and “Which is the right one for me?”
Worry not, dear homebuyer, for the answers are close at hand.
One of the most commonly offered loan products in today’s market is the fixed-rate mortgage. Some mortgage brokers and financial experts refer to them as “vanilla wafer mortgages,” and for a good reason – they are a plain, safe and understandable option. The way this fully amortizing mortgage works is all in the name – the interest rate on the note will remain the same throughout the term of the loan. While other types of loans might see their interest rate fluctuate over time, fixed-rate mortgages never change.
One reason why many would-be homeowners opt for fixed-rate mortgages is because of their consistency. For the duration of the loan, not only does the interest rate remain the same, but so does the payment structure. If you choose a fixed-rate mortgage for your home, the monthly payment also remains unchanged. The payment itself is calculated by taking into account the amount of the loan, the length of the loan, the interest rate and compound frequency.
The primary alternative to the fixed-rate mortgage is the variable rate mortgage, referred to as an adjustable-rate or floating-rate mortgage in the United States. It is essentially the opposite of its fixed-rate counterpart, as the interest rate on the outstanding balance varies throughout the duration of the loan. With a variable rate mortgage the interest rate fluctuates with market conditions and can change how much of your payment is being applied to the interest vs principle. Generally, your payment amount will remain fixed for the duration of the term and it will only be the allocation towards interest or principle that will change.
Like other types of mortgages, those with a variable-rate mortgage can make early payments without incurring any penalties. This can help helpful, as earlier payments will decrease the total cost of the loan. However, unlike other loans, prepayments will not shorten the term. When the rate changes, the new rate is applied to the remaining amount left to pay.
If a homeowner elects to refinance their variable-rate mortgage, they would then take out a new mortgage and proceed to pay it off. The amount paid before refinancing would count as a prepayment for the new mortgage.
Pros and cons
By now, you’re likely still wondering, “Which of these mortgages is the one for me?” It all depends on your personal preference and financial situation. The consistency of rates and payments involved with fixed-rate mortgages make them a good choice for starters. That being said, they do tend to be a bit more on the expensive side. The reason for this is because they tend to have higher interest rates than short-term loans. But don’t let that information be a deterrent to you; fixed-rate mortgages may be expensive, but their consistency along with the ease of understanding the payment structure makes them a good first choice for a new homeowner. Once the rate is locked in, you’ll never have to worry about it throughout the term of the loan.
Speaking of rising interest rates, those tend to have a direct impact on variable-rate mortgages. These loans start with lower rates and are usually cheaper than their fixed-rate equivalents, but they are prone to changes over time. Also, the lower initial rate is not an indicator of what the future cost of borrowing will be when changes do occur. That does evoke a sense of uncertainty for some, but those who chose this type of loan should have a general understanding that there is some risk involved with variable-rate mortgages. If you tend to be more risk-averse, a fixed-rate mortgage may be the better option for you.
As previously stated, the type of mortgage you choose is strictly up to you. If you’re less likely to take risks, do not mind paying a bit more and would like a more consistent loan, you should choose the fixed-rate mortgage. If you’re looking to save some money upfront and are willing to take the risk of dealing with rising and falling interest rates, you might consider choosing a variable-rate mortgage instead.If you’re still having trouble making a decision, you can browse and compare mortgage products from various lenders and see how the numbers stack up. You can also speak to a mortgage broker, who can help you find the best possible rate and dispense valuable advice about fixed and variable rate mortgages.