When you are applying for a mortgage or refinancing an existing mortgage, one important choice you have to make is between a fixed-rate and a variable-rate mortgage. Each loan has its own strengths and weaknesses, and neither is a perfect fit for every homebuyer/homeowner.
In a fixed-rate mortgage, the mortgage rate/interest rate for the loan remains constant for the entire loan term, which may be anywhere between 10 and 30 years. The monthly payments in a fixed-rate mortgage remain consistent, although they contain different proportions of the interest and principal loan amount depending on where you are in your amortization period. Some important characteristics of a fixed-rate mortgage are:
- They offer more predictability when it comes to debt management and managing your monthly expenses. When you know you only have to pay a fixed amount each month towards your mortgage, it’s easier to calculate how much you can save or how much more debt you can incur (personal loan, auto loan, etc.).
- A fixed-rate mortgage protects you in an uncertain interest rate environment, but this is a double-edged sword. With a fixed rate, you benefit when the interest rates rise, but even when they fall, you are stuck paying a monthly mortgage at the original rate.
- It may be difficult to qualify for a fixed-rate mortgage when the interest rates are high, even though the banks would prefer to lock borrowers in for the long term at a high-interest rate. The difficulty stems from an affordability perspective. The monthly mortgage on a $400,000 loan can vary by as much as $500 per month if there is a two percentage point difference. This can significantly impact your debt-to-income ratio and hence, your qualification for the mortgage.
How Is A Fixed-Rate Mortgage Calculated
Let’s say you are trying to buy a property worth $800,000, and you are aiming to put down 20% of that sum, so you are essentially borrowing $640,000. The following payments don’t include property taxes, PMI, and home insurance.
- If you can lock in a 3.5% 30-year fixed rate, your monthly payment would be about $2,875. In the first year, almost two-thirds of your yearly mortgage payment will be made up of interest, while the remaining one-third will be the principal amount.
- At a 6% interest rate and a 30-year fixed-rate mortgage, your monthly payment will be about $3,840.
Variable-Rate Mortgage/Adjustable-Rate Mortgage
In a variable-rate mortgage or an adjustable-rate mortgage, the rates may vary at regular intervals. These intervals can be monthly, bi-monthly, quarterly, yearly, etc. The variable interest rates typically follow a benchmark, typically the Prime Rate or the CMT (Constant Maturity Treasury).
Variable-rate mortgages can be structured in a few different ways. A Hybrid variable-rate loan offers a mix of fixed-rate and variable rates. For example, a 5/1 hybrid loan will have a fixed interest rate for the first five years of the amortization period. Afterward, the interest rate will change every year. There will be a margin that states the maximum amount the interest rate can rise at each rate change and a maximum amount the rate can change over the life of the loan.There are interest-only mortgages where you only pay the interest you owe for a predetermined time, and once it’s over, you start paying off the principal.
Important characteristics of a variable-rate mortgage are:
- Many Adjustable Rate Mortgages (ARM) or variable-rate mortgages start with a relatively low-interest rate, which may be appealing to borrowers struggling with mortgage affordability. However, once the interest rate starts tracking the benchmark, the monthly payments can suddenly go up causing rate shock
- Variable-rate mortgages allow homeowners to track the changing interest rates. When the interest rates are high, the monthly payments go up. When the interest rates are low, they benefit from the interest climate, and the monthly payments go down. This inconsistency can make financial planning difficult, especially if you calculate your mortgage affordability at a low rate.
How Is A Variable-Rate Mortgage Calculated
Let’s say you are financing $800,000 and putting 20% down. The initial interest rate you get is about 4%, subject to change after a year. Your monthly payment can jump by about $370 if the interest rate goes up by just 1%. But it can also go down if the interest rates are coming down.
What’s The Right Choice For You?
The right choice for you will depend upon a number of factors, including the current interest rates, your mortgage affordability, whether predictability is more important to you, or a low-interest rate for the first few months.
If the interest rates are historically low, like they were during the pandemic, a fixed-rate mortgage may be the smart choice. You can lock in a good rate, and the chances of the rates going up over the amortization period would be significantly higher compared to the chance of interest rates going below what you lock in. A fixed-rate mortgage will also be more predictable.
However, if the interest rates are relatively high, you may consider taking out a variable-rate mortgage (ideally a hybrid with a low initial interest rate). This will give you a predictable window and may give the market enough time to cool off.
Factors like interest rates can also impact your choice. If you are on track to improve your credit score, which may help you land a better rate, you may consider taking a variable-rate mortgage first and then refinance to a fixed rate when your score is better.