How to Choose Between Fixed vs Variable Rate Mortgages
Although many of us would like to buy a house with the upfront crash, realistically, it's not happening for a lot of us. That's where mortgages come in, providing you with the money to acquire and finance a home over time. Mortgages come in all sizes and shapes. From open vs. closed to fixed rate vs. variable rate, and terms ranging from a few months to years, even over a decade.
While mortgages offer a great financial solution, finding the right mortgage involves more than creditworthiness or raising an adequate down payment. A good credit score guarantees mortgage approval, but what option best suits your needs and situation? On face value, a mortgage with the lowest interest rate is seemingly the best, but various factors impact the total cost. Understanding the difference between fixed and variable rates can help you pick a mortgage matching your risk tolerance and other financial considerations. Let's look at some aspects to help you make an informed decision on finding the right mortgage.
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Fixed vs Variable Rate Mortgages
Fixed-Rate Mortgage Definition
The interest rate remains the same throughout the mortgage term. This means you pay the same monthly amount, which accounts for the interest and principal repayment.
Variable-Rate Mortgage Definition
The interest rate is tied to the prime rate. This means it varies per the prime rate and can fluctuate, increasing the interest or reducing it in certain periods throughout the mortgage term.
Pros & Cons of a Fixed-Rate Mortgage
Pros: Predictability and stability are the main advantages of the fixed-rate mortgage. Since the interest rate is constant, you know how much money goes to the interest and the principal. This means you can predict how long the mortgage repayment will take. Stable repayments give you peace of mind and help you make effective financial plans.
Cons: The primary disadvantage of the fixed-rate mortgage is the high cost. You can expect a higher interest rate compared to a variable rate mortgage. While it is a small price to pay for consistency, it increases the total cost of the loan. Moreover, should you decide to break the contract, for example, if you want to sell the property, you will incur a higher break penalty.
Pros & Cons of a Variable-Rate Mortgage
Pros: The most notable variable rate mortgage advantage is the lower interest rates. If the interest rates don't go high, you can potentially enjoy lower loan costs. If the prime rate falls during the mortgage terms, you stand a chance to enjoy lower total loan costs. Other pros of the variable rate mortgage are the lower penalty if you break the mortgage contract and the flexibility to switch to a fixed-rate mortgage.
Cons: The major downsides of the variable rate mortgage are lack of stability and the potential of incurring higher loan costs. Due to the prime rate fluctuation, the interest rate can increase, meaning most of your repayment goes to the interest, increasing the loan cost. Moreover, if you convert, the current interest rate will apply, which could be higher, further increasing the total cost.
What's the prime rate, and why is it relevant?
The simplest prime rate definition is, it's the banks' interest rate for the most qualified borrowers. The most qualified borrowers are those with excellent credit scores. For the banks, these candidates are mostly corporations. The prime rate is significantly reliant on the federal funds rate, which is the interest rate the banks charge other banks that borrow money overnight.
As you consider your loan cost, especially if you are leaning more towards a variable rate mortgage, the prime rate is a relevant check. The prime rate is relevant since its change indicates a potential change in the mortgage interest rates.
How to choose between fixed and variable mortgage?
On face value, if you yearn for peace of mind, a fixed-rate mortgage is recommended since the interest rate remains the same. However, if you speculate favourable prime rate changes, meaning it will more likely stay the same or decrease, a variable rate mortgage is ideal since you will enjoy lower mortgage costs.
Besides the interest, your risk tolerance and plans within the loan term also count. If you don't fancy taking financial risks, a fixed-rate mortgage is ideal since you know how much and how long it will take to repay the loan.
Your near-future plans can also help you choose between fixed rate vs variable rate considering the potential to break the mortgage contract. For instance, if you expect to sell and move or access a huge chunk of funds that can be used for lump sum mortgage payments, a variable-rate mortgage is ideal since you won't incur hefty penalties.
When choosing between a fixed vs variable rate for your mortgage, it's important not to jump into an option because of a low-interest rate. Look at the bigger picture for a vivid idea of the total mortgage cost. There is no one-size-fits-all answer on the best option to pick since it depends on your unique situation. Considering your immediate and expected financial situation is the most effective way to ensure you make an informed mortgage decision.
Frequently Asked Questions
The interest rate remains the same, translating to stability and predictability, making it easier to stay on top of your financials.
Lower interest rates, flexibility to switch to a fixed-rate mortgage, and friendlier penalties should you opt to break the mortgage contract.
There is no specific period when you should switch. However, if you like the current rates and are expecting a rise that makes you anxious, then switching to a fixed-rate mortgage is ideal, giving you the peace of mind you deserve.