Fluctuating interest rates affect fixed- and variable-rate mortgages differently. New homebuyers and homeowners with mortgages coming up for renewal are faced with the choice, but what’s the difference between fixed and variable rate mortgages? Let’s explore.
Fixed vs Variable Rate Mortgages: Understanding the Differences
With a fixed-rate mortgage, borrowers’ interest rates and payments remain unchanged during the mortgage term. This means that the borrower’s monthly payments will remain constant, making planning and budgeting each month’s mortgage payment easier. The fixed interest rate is typically set when the loan is originated and does not change, regardless of any fluctuations in the market interest rates. Fixed-rate mortgages are a popular choice among homebuyers who prefer the stability and predictability of a consistent payment over the life of the loan.
With a variable-rate mortgage, homeowners’ interest rates will rise or fall based on the lender’s prime interest rate. The interest rate is typically tied to a financial index, such as the prime rate, and may change periodically based on changes in the index. Variable-rate mortgages may be suitable for homebuyers who are comfortable with fluctuations in payments and feel the interest rate may drop in the future.
Benefits and Drawbacks of Each Mortgage
Both types of mortgages have their pros and cons.
For a fixed-rate mortgage, borrowers know when they will pay off their mortgage. This allows someone to budget accurately every month because they know their payment for the prescribed term. The interest rate does not change, regardless of any fluctuations in the market interest rates. This means that borrowers are protected against any potential increases in interest rates, providing peace of mind and helping to avoid payment shock. Because the interest rate never changes, borrowers could pay more or less in interest than with a variable-rate mortgage.
At the same time, a fixed mortgage interest rate is typically higher than the variable alternative. Not only does that mean a potentially higher overall cost, but it also makes it more difficult for some borrowers to qualify. Fixed-rate mortgages are less flexible than adjustable-rate mortgages, as the interest rate remains the same for the life of the loan. This means borrowers cannot take advantage of any potential decreases in interest rates without refinancing. Plus, should the borrower decide to end the mortgage prematurely, they will incur greater penalties than a variable rate.
So, what about the advantages and disadvantages of variable mortgage rates?
The interest rate on a variable-rate mortgage is typically lower than with a fixed rate. Should the prime rate move, so too will the mortgage interest rate. If the prime rate increases, more of the payment will be allocated to interest. If the rate falls, more will go toward the principal, extending the amortization period. Some variable-rate mortgages include caps or limits on how much the interest rate can increase, which can protect against significant interest rate increases. Those with a variable-rate mortgage concerned about an imminent interest rate hike can transition to a fixed-rate mortgage anytime.
However, with a fluctuating interest rate, there is more uncertainty in budgeting for homeownership. The higher monthly payments could result in a higher overall mortgage cost. If interest rates increase significantly, borrowers with variable-rate mortgages may have difficulty making their mortgage payments, resulting in default and potentially foreclosure. At the same time, some variable-rate mortgages may have prepayment penalties if the borrower pays off the loan early or refinances.
A Note About Prime Rates
But wait a minute. What is a prime rate anyway?
The prime rate is the interest rate banks charge their most creditworthy customers for loans. It is generally considered the benchmark rate for many types of loans, including adjustable-rate mortgages (ARMs), home equity lines of credit (HELOCs), and credit cards. Individual banks set the prime rate, typically based on the federal funds rate set by the Federal Reserve, which is the interest rate banks charge each other for overnight loans to meet reserve requirements. The prime rate can fluctuate over time based on changes in the federal funds rate or other economic factors. It is often used as an indicator of the economy’s overall health. Borrowers with a good credit score may be able to secure loans at or near the prime rate, while borrowers with lower credit scores may be offered loans with a higher interest rate.
Types of Fixed and Variable Rate Mortgages
Meanwhile, there are variations of a fixed- and variable-rate mortgage:
Open Fixed: Borrowers can prepay in full or part to change to another mortgage term without fees. With an open fixed mortgage, borrowers have the flexibility to make additional payments on their mortgage, which can help them pay off their mortgage faster and save money on interest charges. This type of mortgage benefits borrowers with fluctuating income, such as self-employed individuals, or those who anticipate receiving a large sum of money in the near future, such as an inheritance.
Closed Fixed: Homebuyers will see their interest rate and payments remain the same throughout the term. The interest rate is fixed for a specified period, such as one, two, three, five or 10 years, and the mortgage cannot be paid off or renegotiated before the end of that term without incurring penalties. This means that borrowers are committed to the mortgage for the entire term and cannot make any significant changes to the mortgage without paying a penalty. At the end of the fixed term, borrowers can renew the mortgage with the same lender or switch to a different one.
Open Variable: Clients can make as many prepayments as they want and either pay off the total balance or switch to a different term without penalties. With an open variable mortgage, borrowers have the flexibility to make additional payments on their mortgage, which can help them pay off their mortgage faster and save money on interest charges. This type of mortgage benefits borrowers with fluctuating income, such as self-employed individuals, or those who anticipate receiving a large sum of money soon, such as an inheritance.
Closed Variable: Homeowners will make the same monthly payments throughout the mortgage term. The interest rate is variable and is fixed for a specified period, such as one, two, three, five or 10 years. The mortgage cannot be paid off or renegotiated before the end of that term without incurring penalties. This means that borrowers are committed to the mortgage for the entire term and cannot make any significant changes to the mortgage without paying a penalty. At the end of the fixed term, borrowers can renew the mortgage with the same lender or switch to a different one.
Adjustable Rate: An adjustable-rate mortgage (ARM) is a type of mortgage where the interest rate on the loan is variable and may change over time based on fluctuations in an underlying financial index. The interest rate on an ARM is typically fixed for a certain period, often three, five or seven years, before becoming adjustable. After the fixed rate period ends, the interest rate may adjust up or down, depending on changes in the financial index.
Lock and Roll: “Lock and roll” is a term that is sometimes used to describe a feature of adjustable-rate mortgages (ARMs) that allows borrowers to lock in their interest rate at any time during the life of the loan. This feature gives borrowers greater flexibility and control over their mortgage payments, especially in a rising interest rate environment. With a lock and roll feature, borrowers can lock in their interest rate for a set period, typically ranging from 30 days to several months, at any point during the life of the loan. This can protect borrowers against rising interest rates and help them better manage their monthly mortgage payments.
What’s Right for You?
Should you choose a fixed or variable mortgage rate?
Since real estate is generally considered a conventional safe-haven asset in any economy, many choose the fixed option because it allows for a steady approach to managing finances. However, some homebuyers have opted for the variable rate and have enjoyed savings. Work with a professional financial advisor to determine what’s best for you in your specific situation.
