With the current economy and rumours of a recession looming, homebuyers may feel unsure of whether to choose a fixed or variable rate mortgage. What’s the difference? The difference between these two rate types is in their names: one doesn’t change through the mortgage term, while the other can.
A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest rates change. As a result, your payments will vary as well (as long as your payments are blended with principal and interest).
Fixed interest rate loans are loans in which the interest rate charged on the loan will remain fixed for that loan’s entire term, no matter what market interest rates do. This will result in your payments being the same over the entire term. Whether a fixed-rate loan is better for you will depend on the interest rate environment when the loan is taken out and on the duration of the loan.
When a loan is fixed for its entire term, it remains at the then-prevailing market interest rate, plus or minus a spread that is unique to the borrower. Generally speaking, if interest rates are relatively low, but are about to increase, then it will be better to lock in your loan at that fixed rate. Depending on the terms of your agreement, your interest rate on the new loan will stay the same, even if interest rates climb to higher levels. On the other hand, if interest rates are on the decline, then it would be better to have a variable rate loan. As interest rates fall, so will the interest rate on your loan.
So What to Choose?
This discussion is simplistic, but the explanation will not change in a more complicated situation. Studies have found that over time, the borrower is likely to pay less interest overall with a variable rate loan versus a fixed rate loan. However, historical trends aren’t necessarily indicative of future performance. The borrower must also consider the amortization period of a loan. The longer the amortization period of a loan, the greater the impact a change in interest rates will have on your payments.
Therefore, adjustable-rate mortgages (ARM) are beneficial for a borrower in a decreasing interest rate environment, but when interest rates rise, then mortgage payments will rise sharply. Use a tool like Investopedia’s mortgage calculator to estimate how your total mortgage payments can differ depending on which mortgage type you choose.
A 2001 study found that choosing a variable-rate mortgage over a fixed rate was the better option nearly 90% of the time between 1950 and 2000. But what about recently? With daily fluctuations it is best to consult a mortgage professional for an update on the best current choice in their opinion. Your willingness to take risk and trust the market will also come into play.
Marina Vander Heyden | Mortgage Agent | Vine Group | email@example.com | (647) 332-9857 | 555 Bloor St. East, Toronto, ON, Canada M4W 1J1