Fixed Rate vs Variable Rate Mortgages: How Do I Choose

Making the decision on whether to utilize a fixed rate mortgage or a variable rate mortgage is not always as simple as it should be due to the various factors that go into making a mortgage decision.

Determining which type of mortgage is right for you has a lot to do with how you handle risk and volatility in your financial planning. Even if a variable rate mortgage will save you money in the long run if you are the type of person that needs cost certainty over a long time horizon a fixed rate mortgage may allow you to sleep better at night.

Fixed Rate Mortgages Explained

A fixed rate mortgage is any mortgage where the interest on the principal is preset for a specified period of time. Generally known as the “mortgage term” this can typically range anywhere from 1 to 5 years and in some cases 10 or 15 years in Canada. Up to 30 year fixed rate mortgages are available in the United States.

Most homeowners who select the fixed rate mortgage will choose the 5 year fixed mortgage to lock in an interest rate for a 5 year period. During the front end of the loan ammortization most of your fixed monthly payments go to service the interest on the principal. In later years, more of the monthly payment will go towards paying the principal balance until the terms of the mortgage have been satisfied.

Fixed rate mortgages are great for people who like cost certainty and family planning years in advance. If you are extremely risk averse and can not stomach volatility in interest rates affecting your monthly principal amount paid then opt for a fixed rate mortgage.

Variable Rate Mortgages Explained

A variable rate mortgage is any mortgage that has fixed payments but an interest rate that fluctuates with any adjustments to the lending institutions prime lending rate.

When interest rates decrease the monthly payment is kept constant but more of the payment goes to servicing the principal balance, likewise when interest rates rise the monthly payment is kept constant while more of the monthly payment goes to service interest on the loan.

A variable rate mortgage is usually some combination of the bank’s prime rate +/- a small percentage. For example a bank may advertise a variable rate mortgage that is prime – 0.6%. If their prime lending rate was 2.5% then the loan interest rate would be 2.5 – 0.6 = 1.9% interest.

Variable rate mortgages can be of greater benefit to homeowners in the long run. Studies have shown over the last 50 years a borrower would have saved an average of $22,000 for every $100,000 borrowed over a 15 year amortization if he had borrowed at the prime rate rather than locking in 5 year fixed terms.

If you prefer the safety of knowing exactly how much you are paying all the time and “sticking to the schedule” forward planning in your life choose a fixed rate mortgage. If you can stomach a little interest rate volatility in the long run there are savings to be had choosing a variable rate mortgage locked in with the prime lending rate.