Comparing the Fixed Rate Mortgage and Variable Rate Mortgages: Choosing Which Is Best For You

For the most part, there are two types of mortgages that most homeowners will choose from – fixed rate mortgages and variable rate mortgages. The product that is right for one family today may not be right for another tomorrow, and the reasons for this can be numerous. Let’s compare fixed and variable rate mortgages looking at the reasons why you might choose each product.

Fixed rate mortgages

A fixed rate mortgage is one that has a fixed interest rate throughout the life of the mortgage. The interest rate is determined at the time you take out the mortgage and is based on the prime interest rate, plus ‘points’ (each point is one percent in interest) for the lender. Lenders can charge anywhere from one to five or more points. Since the interest rate is the same during the entire term of the mortgage, the monthly (bi-weekly or weekly) mortgage payments will also remain the same.

Variable rate mortgages

Variable rate mortgages have an interest rate that changes at set times during the term of the mortgage. The interest rate is determined at the start of your mortgage, once again based on the prime interest rate plus the lender’s points. The points at which the interest rate will change are also set, usually one to three years from the beginning of the mortgage. When the interest rate is set to change, it is once again based on the prime interest rate plus the lender’s points. This could mean that your interest rate and your monthly payments might go up or down.

One of the major differences with variable rate mortgages is a payment cap exists. This is protection for you that your payments will not exceed a specific amount of money. However, that doesn’t mean that your interest rate won’t go up as high. In the cases where the interest rate rise would take your payments beyond your payment cap, you payments aren’t any higher than the cap. However, you will be paying more interest and less to the principal of your mortgage.

When to choose a fixed rate mortgage

There are very specific times that you will want to choose a fixed rate mortgage over a variable rate mortgage:

• When the interest rates are at an all time low. If the interest rates are low, you will want to lock in those great rates for as long as possible. Chances are that the interest rate will only rise in the future, so you want to lock in that rate as long as you can. This is when homeowners are encouraged to take out a mortgage for a longer term.
• When you’re maxing out the payments you can afford to buy the house you want. For many families, they borrow the maximum amount of money they can to purchase the most house they can. In this situation, you need to be able to afford your payments no matter what the market is doing, and the predictability can help you budget.
• When you want the stability of monthly payments. If you want to know what your monthly payments will be, as well as how much you’re paying on your mortgage in principal and interest, a fixed rate mortgage is the way to go.

When to choose a variable rate mortgage

There are various times that it’s prudent to choose a variable rate mortgage:

• When the interest rates are high. If the prime rate is at an all time high and the predictions are that it will go down over the next few years, then choosing a variable rate mortgage may be best for you. It will mean that you’re not stuck with the higher interest rates for long and you’ll be able to take advantage of the lower interest rates when your mortgage interest rate comes up for the first change.
• When you have the ability to make higher payments and the interest rate could potentially go down. If you’re not maxed out on your mortgage amount and can afford higher payments and the interest rates may go down, you may want to consider a variable rate mortgage.
• When you don’t plan on staying in the house for a long time. If you’re planning on living in the house for a short time (only three to five years), a variable rate mortgage is a good way to go. You’ll be able to pay off more of your mortgage amount because most variable rate mortgages are more lenient on extra payments, payoffs and assumption of the loan by another person.
• When you need additional options. Variable rate loans offer products that fixed rates just can’t including interest-only loans, Options ARMs, and longer term mortgages (like 40 and 50 year products). If you need flexibility, a variable rate loan is the best way to achieve it.

Making the Decision

The decision between a variable and fixed rate mortgage will also depend on the type of mortgage that you want. Some of the various types of mortgages are only available in fixed rate mortgages, such as balloon mortgages and jumbo mortgages. Interest only mortgages are generally available in only variable formats. Understanding what will best fit your needs as a borrower is the best way to make the decision on which type of loan is right for you.

The best thing to do is to look at the history of the prime interest rate before going to a lender to ask for a mortgage. Having this information and knowledge will give you an edge with the lender, especially if they try to talk you into a variable rate mortgage. If the interest rates have been low for quite some time, chances are they will rise soon, while if they’ve been high for some time, they are likely to drop.