Comparison of Fixed and Variable Rate Mortgages

G. Stephanie

04/30/2024

Comparison of Fixed and Variable Rate Mortgages

Learn the key differences between fixed and variable rate mortgages, their benefits and drawbacks, and how to choose the right option for your financial situation.

When purchasing a home, securing a mortgage is typically the largest financial decision you will make.

One of the key decisions you’ll face when considering a mortgage is whether to choose a fixed-rate or a variable-rate mortgage.

What is a Fixed-Rate Mortgage?

A fixed-rate mortgage is a home loan where the interest rate remains constant throughout the entire term of the loan, whether it is 15, 20, or 30 years.

This stability is the main selling point of a fixed-rate mortgage, as it ensures that the borrower will pay the same amount each month for the duration of the loan.

Since the interest rate is set at the beginning and does not fluctuate, borrowers can plan their finances with confidence, knowing exactly how much they will need to pay each month.

1. Key Features of Fixed-Rate Mortgages:

Stable Monthly Payments: The most appealing feature of fixed-rate mortgages is the predictability of the monthly payments. Borrowers can easily budget their finances knowing that their principal and interest payments will remain the same.
Interest Rate: The interest rate is set at the time of signing and does not change over the life of the loan. Even if market interest rates fluctuate, your rate will remain locked in.
Long-Term Security: Fixed-rate mortgages provide long-term security against rising interest rates. For homeowners who plan to stay in their home for a long time, this offers peace of mind.

2. Advantages of Fixed-Rate Mortgages:

Predictability: Since your payments are the same every month, it’s easier to plan your budget and avoid surprises.
Protection from Rising Rates: Even if the market interest rates increase, your rate will remain the same, potentially saving you money compared to a variable-rate loan.
Ideal for Long-Term Homeowners: For individuals who plan to stay in their homes for many years, fixed-rate mortgages are often the best option due to their stability and long-term security.

3. Disadvantages of Fixed-Rate Mortgages:

Higher Initial Interest Rates: Fixed-rate mortgages often come with higher initial interest rates compared to variable-rate mortgages. This can result in higher monthly payments at the start of the loan.
Less Flexibility: If market interest rates decrease, you’ll still be paying the same rate. To take advantage of lower rates, you would need to refinance, which can involve additional fees and paperwork.
Higher Long-Term Costs: Over the life of the loan, the higher initial interest rates can lead to paying more in interest compared to a variable-rate mortgage with lower initial rates.

What is a Variable-Rate Mortgage

A variable-rate mortgage (also known as an adjustable-rate mortgage or ARM) is a type of home loan where the interest rate is not fixed but instead fluctuates periodically based on changes in a benchmark interest rate or index, such as the LIBOR (London Interbank Offered Rate) or the U.S. Prime Rate.

Typically, the interest rate on a variable-rate mortgage is lower than that of a fixed-rate mortgage during the initial period, which may range from a few months to several years.

After this initial period, the rate adjusts at set intervals, usually annually, depending on the terms of the loan.

1. Key Features of Variable-Rate Mortgages:

Initial Lower Interest Rates: Most variable-rate mortgages offer a lower initial interest rate compared to fixed-rate loans, which can make the initial monthly payments more affordable.
Adjustment Period: After the initial fixed-rate period, the interest rate adjusts based on the performance of a market index, which means monthly payments may increase or decrease over time.
Caps and Floors: Many variable-rate mortgages include caps and floors that limit how much the interest rate can increase or decrease at each adjustment period. These features offer some protection from extreme fluctuations in the market.

2. Advantages of Variable-Rate Mortgages:

Lower Initial Payments: With lower initial rates, variable-rate mortgages are more affordable in the short term. This can be especially appealing for homeowners who don’t plan to stay in their home long-term or those who expect their income to rise over time.
Potential for Lower Rates Over Time: If interest rates decrease or remain stable, your mortgage payments may decrease as well, potentially saving you money in the long run.
Flexible Terms: Variable-rate mortgages are ideal for borrowers who anticipate that they may be able to refinance or sell their home before the rate adjusts significantly.

3. Disadvantages of Variable-Rate Mortgages:

Uncertainty: The biggest disadvantage of a variable-rate mortgage is the uncertainty. If market interest rates rise, your mortgage payments could increase significantly, making it harder to budget.
Rate Increases: After the initial fixed-rate period, the adjustments may result in higher payments, especially if interest rates increase significantly over the life of the loan.
Complexity: Variable-rate mortgages can be more difficult to understand due to the terms associated with rate adjustments and caps. Borrowers must be comfortable with these complexities to avoid surprises.

Key Differences Between Fixed-Rate and Variable-Rate Mortgages

While both types of mortgages serve the same purpose—helping you finance a home—there are several key differences between fixed-rate and variable-rate mortgages.

1. Interest Rate Stability

The interest rate is set and remains unchanged for the life of the loan, offering stability and predictability in monthly payments.

The interest rate fluctuates over time, depending on the movement of a benchmark rate or index. Your monthly payment can change, making it less predictable.

2. Initial Payments

Monthly payments are typically higher from the outset, as the interest rate is locked in and fixed for the term of the loan.

The initial rate is usually lower, resulting in lower monthly payments during the early years of the loan.

3. Long-Term Costs

Fixed-Rate Mortgage: While the initial monthly payments may be higher, your total cost over the life of the loan is predictable.

However, you could end up paying more in interest if you stay in the home for an extended period, especially if interest rates decrease.

Variable-Rate Mortgage: Your long-term costs depend on how interest rates change over time. If rates remain low or decrease, you could save money compared to a fixed-rate mortgage. However, if rates increase, your payments could rise, leading to higher overall costs.

4. Risk

Offers minimal risk since the interest rate is fixed. Even if market rates increase, your payments will remain the same.

Carries more risk because your payments could increase significantly if interest rates rise. This unpredictability can be a concern for borrowers with tight budgets or long-term financial plans.

5. Best for

Ideal for those who value stability, plan to stay in their home for a long time, and want predictable monthly payments.

Best for those who anticipate that they may not stay in the home long-term or who are comfortable with some level of risk. It’s also suitable for those who expect interest rates to remain stable or decrease over time.

Both fixed-rate and variable-rate mortgages offer distinct advantages and disadvantages. Fixed-rate mortgages provide stability and predictability, making them ideal for long-term homeowners who want to avoid the risk of rising interest rates.

On the other hand, variable-rate mortgages offer lower initial payments and the potential for cost savings if interest rates remain low, but they come with the risk of fluctuating payments over time.

By carefully considering your financial goals, risk tolerance, and plans for the future, you can choose the mortgage type that best suits your needs and helps you achieve homeownership with confidence.