Buying a home is something that Americans dream of achieving. However, the thought of paying cash for a property is out of reach for many. For most of us, we need to leverage a mortgage from a lender to reach out goal of being a homeowner.
Is today’s economy, lenders are willing to sell you a mortgage to cover the costs of buying real estate. When applying for a mortgage, you’ll need your closing costs and down payment ready to go. Taking on mortgage debt is a long-term commitment, and you’ll end up paying back the price of the principal, plus additional interest.
Lenders are in business to make money off of your mortgage, and they do that by charging interest on the money you loan. Many Americans are so happy to receive approval for a mortgage that they rarely stop to examine the interest rate on the deal. As a result, many new homeowners end up paying far more in interest costs than they would have if they spent a little time negotiating rates with the lender.
On top of negotiating rates, before you commit to a mortgage, ask the lender to give you their pricing on variable and fixed-rate mortgages. Do you understand the difference between fixed and variable rates? This brief guide will explain everything you need to know about these two types of mortgage facilities.
Fixed-Rate Mortgages Explained
- 1 Fixed-Rate Mortgages Explained
- 2 Variable Rate Mortgages Explained
- 3 Variable Rate Interest and Indexed Rates
- 4 Full-Term Variable Rate Loans
- 5 The Pros and Cons of Variable and Fixed-Rate Mortgages
- 6 Variable Rates Pros
- 7 Variable Rates Cons
- 8 Fixed Rates Pros
- 9 Fixed Rates Cons
- 10 Wrapping Up – Key Takeaways
When lenders offer you a fixed-rate mortgage, they provide you with a fixed interest rate for the entire duration of the loan. This fixed rate means that you pay the same monthly installment on the mortgage, regardless of the economic conditions present in the market. If interest rates go up, it doesn’t affect your monthly payment. However, the downside is that if interest rates go down, you don’t get any benefit either.
When facilitating your mortgage, lenders are willing to take a bet on the uncertainty in the market, over the length of the loan term. In other words, they rely on the ups and downs in the interest rate to provide an even playing field where both you and they benefit.
Many Americans that choose a fixed-rate mortgage feel that it’s the sensible option when compared to other facilities like variable and adjustable-rate mortgage products. You lock yourself in at a specific rate, and what you see is what you get for the duration of the mortgage contract. However, there’s nothing that creates more resentment in a homeowner, than locking in a mortgage interest rate, only to see interest rates begin to fall.
Therefore, timing the market when buying a home is a vital strategy if you want to take a fixed-rate loan.
For example, we are currently at the peak of a tightening period where the Federal Reserve has been steadily increasing the Federal funds rate for the last 4-years. While the current Fed funds rate is only 2.5-percent, the Fed is set to end this economic cycle and start with the next period of easing where they drop interest rates.
The Federal funds rate is the determining factor in setting the interest rate in which banks loan each other money. However, it also plays a role in the overall interest rate environment. When banks and other lenders decide to write you a mortgage, they rely on the LIBOR (London Inter-Bank Offered Rate), and the prime lending rate.
Therefore, any rise or fall in the Federal funds rate also affects the interest rate applied to your mortgage facility. Typically, banks will fix your mortgage interest rate at the current LIBOR or prime rate, plus 2-points. Lenders set this figure in stone, and any fluctuations in either the Federal funds rate, the prime rate, or LIBOR will not affect your monthly payment.
Therefore, if you were to take on a mortgage in the current economic climate, then you are fixing your interest rate at the top of the cycle. Taking this strategy means that you are buying in at the top of the market, and fixing your interest rate at the highest level since 2000.
This strategy, therefore, does not make much financial sense. If you want a fixed-rate mortgage, then it’s better to save for the next few years until the Federal Reserve is at the peak of lowering interest rates in the next easing cycle.
However, many Americans don’t want to continue renting for another 4-years until rates cut back to a favorable level. If you have a family and you’re looking to move out of your tiny apartment into a home, then you most likely want to find a home right now.
Variable Rate Mortgages Explained
If you decide to jump into the real estate market and acquire a mortgage in the current economic conditions, it may be a prudent decision to opt for a variable interest rate loan.
With a variable rate loan, the bank lets your interest rate “float” against a benchmark, such as LIBOR plus 2-points. As a result of the variable rate, the cost of your monthly payment may fluctuate depending on the overall interest rate market.
Therefore, in our current economic environment, where rates are set to fall over the coming years as the Fed moves into an easing cycle, a variable interest rate loan may make more financial sense. By taking a variable rate mortgage, you benefit from the drop in interest rates, reducing the cost of your monthly payment on the mortgage facility.
However, while it may seem like a prudent financial move to purchase a variable rate mortgage, there is also a chance it could burn you as well. As we previously mentioned, the banks and financial institutions rely on uncertainty in the market. Believing that rates will fall forever is a foolhardy approach.
Markets move in cycles, and just as the current tightening policy is set to end and usher in a new era of easy money, that cycle will also end eventually. Most Americans take mortgage facilities for periods of 15, 20, or 30-years. To think that you won’t see another tightening cycle in this timeframe is unreasonable.
Therefore, you may benefit from falling interest rates for a few years, where you see the monthly cost of your payment steadily fall. However, when the market turns, and interest starts to climb – so does your monthly payment.
You may be thinking that you are okay with that, after all, you spent plenty of time benefiting from the decline in interest prices. However, in reality, the chances are that you didn’t save the additional money from your monthly installment. In this case, you probably adjusted your expenses to consume the extra savings on your mortgage payments.
When the market turns, and rates begin to rise, you end up struggling to reach the escalating payments on your mortgage facility. This lack of foresight could end up costing you your home as rates continue to rise, and you can no longer afford the monthly payments, resulting in the bank foreclosing on your home.
Variable Rate Interest and Indexed Rates
Most lenders structure variable-rate mortgages to include both a variable rate margin and an indexed rate. If the bank charges you a variable rate, they assign a margin in the underwriting process of the loan. Most variable-rate mortgages pay a fully indexed interest rate that they base on the indexed rate, plus any margin.
You may qualify to pay only the indexed rate, which banks charge to high-quality credit borrowers in the variable rate loan. Indexed rates are typically secured to the prime rate offered by the lender, or to LIBOR. As a result, you’ll pay interest as per fluctuations in the indexed rate.
Full-Term Variable Rate Loans
These types of variable interest rate mortgages charge you a variable interest rate throughout the entire mortgage period. The bank bases the interest rate on the indexed rate, as well as any margin required. As a result, the interest rate fluctuates over the loan term.
The Pros and Cons of Variable and Fixed-Rate Mortgages
There are pros and cons to both types of mortgages. Deciding on which type of mortgage suits your situation, depends on your risk tolerance and future goals with your home. Here is a quick breakdown of the pros and cons of both facilities.
Variable Rates Pros
- The best feature of variable rate loans is the flexibility you have with the interest rate. In our example of the current economic climate, a variable interest rate may suit your needs. If you don’t have any intention of seeing the mortgage out to the end of its term, then it may benefit you more than a fixed-rate mortgage.
- You could take the variable-rate facility, and then sell your home in a few years when the market begins to turn. Another option would be to refinance the loan to a fixed-rate facility when interest rates start to rise again.
Variable Rates Cons
- If you plan on purchasing your family home, with no intention to sell in the future, a variable rate loan could cost you dearly when the market turns. You still have the option to refinance at this stage, but if the bank denies you a new refinance deal, such as it did to clients in the wake of the 2008 Financial Crisis, then you could be stuck in an uncomfortable financial position. Changes in interest rates over a 30-year mortgage term are nearly impossible to predict, even for elite bankers. Therefore, assuming that the interest market will keep going down, and using this as the basis for taking up mortgage debt, is a foolhardy strategy.
Fixed Rates Pros
- Most American homebuyers are risk-averse, and they prefer the security and safety of a fixed-rate mortgage over a variable-rate mortgage. By amortizing the loan, you can set a fixed monthly payment for the duration of the loan term, even if it’s as long as 30-years. There’s something that inspires confidence when looking at a fixed rate monthly payment, and it allows you to plan and budget for the future, instead of wading in financial uncertainty.
Fixed Rates Cons
- When choosing a fixed-rate mortgage in a falling interest rate market, you’ll end up paying more than you should for your home. Fixed-rate mortgages also don’t allow you to allocate any financial windfalls as a lump sum payment into the mortgage. If you do wish to increase your monthly payment or throw a lump sum into your account, then you can expect to have to pay penalties.
- These “additional funding fees,” don’t apply to variable-rate mortgages. Therefore, if you plan on paying down your mortgage sooner than expected, it’s a prudent strategy to go for a variable-rate facility instead.
- Also, changing banks with your fixed-rate mortgage may even cost you additional charges. Lenders don’t like to transfer secure assets out of their custody, and they will charge you a “breakage fee” for not living up to the terms of your contract.
- Fixed-rate mortgages may also come with additional fees for fixing the interest over the duration of the loan. As a benchmark, the longer the mortgage term, the higher the interest rate charged by the lender, and the higher your monthly repayment.
Wrapping Up – Key Takeaways
Choosing between a fixed-rate and variable-rate mortgage requires plenty of thought on your part before you decide to commit to the loan. A fixed-rate loan may suit you better if you don’t want any surprises in your monthly payments, and you are consistent in how you manage your debt. Considering most Americans prefer consistency over uncertainty, it’s no surprise that fixed-rate loans account for 90-percent of all mortgages written up by banks.
However, if you don’t mind trading a bit of uncertainty for being able to add lump sums to your mortgage and increasing your monthly payments with the extra cash you have on hand, then a variable-rate mortgage may be the better option for you.
Whichever route you decide to go, it’s vital that you understand both the pitfalls and benefits of both facilities. Choose wisely.