Fixed Rate Mortgages Vs. Variable Rate Mortgages

This article will explain the differences between fixed rate, variable rate, and hybrid mortgages, as well as the pros and cons of each to help you make the best decision on which is right for you.

Fixed Rate Mortgages

Fixed rate mortgages, as you may have guessed, have a fixed interest rate for the life of the loan. The terms of the loan are normally 15 or 30 years. Other terms exist (10 and 20 years) but are less common.

Pros of fixed rate mortgages:

· The borrower knows exactly how much they will pay each month for their mortgage, and the amount will never change

· If the market conditions are right, fixed rate mortgages allow home buyers to lock in a low interest rate for the life of the loan.

Cons of fixed rate mortgages:

· The interest rate will often be higher on fixed rate mortgages because the lender does not know what the interest rates will be in the future. The home buyer is paying for the luxury of knowing exactly how much they will pay each month.

· If interest rates drop, home owners with a fixed rate mortgage do not get to pay less each month. They can refinance, but there are costs associated with that as well.

Variable Rate Mortgages

Variable rate mortgages, or adjustable rate mortgages, have an interest rate that rises and falls with the current interest rate. The length of the loan is the same as fixed rate mortgages.

Pros of variable rate mortgages:

· The home buyer may end up with a lower monthly payment than they start out with if interest rates drop.

· The interest rate on variable rate mortgages may be initially lower than a fixed rate mortgage in the same environment because variable rate mortgages pass some of the risk away from the lender to the buyer.

· “Caps” or restrictions on the loan prevent the interest rate from getting too high. A cap is the highest interest rate or monthly payment that the home buyer will have to pay even if the interest rate in the marketplace exceeds it.

Cons of variable rate mortgages:

· The home buyer may end up with a higher monthly payment than they start out with if interest rates rise.

· Even with caps, if the interest rate gets too high, the home buyer may end up not paying off all of the interest they owe each month. This is known as negative amortization, when the loan balance actually increases each month.

Hybrid Mortgages

A third type of mortgage is known as a hybrid mortgage, or hybrid adjustable rate mortgage. Hybrid mortgages combine fixed rate and variable rate mortgages into one loan. For example, the interest rate may be fixed for the first 10 years, after which time the interest rate becomes variable.

Pros of hybrid mortgages:

· The home buyer may get a lower interest rate than a fixed rate mortgage without taking on as much risk as a traditional adjustable rate mortgage.

· The borrower could conceivably get the best of both worlds – rising market interest rates during the fixed rate phase of the mortgage, and falling interest rates during the variable phase.

Cons of hybrid mortgages:

· After knowing how much to pay each month for the first phase of the loan, the home owner will have to get used to the fact that that payment amount could change at any time.

· The borrower could conceivably get the worst of both worlds – falling interest rates during the fixed rate phase of the mortgage, and rising interest rates during the variable phase.

When selecting which type of mortgage is right for you there are two main factors. First, the current interest rates and foreseeable interest rates. Second, the borrower’s tolerance for risk. Home buyers should always do their homework and consult a financial professional before making any decisions that will financially affect the rest of their lives.

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