Fixed vs. Variable Mortgage

In the U.S., mortgages are traditionally fixed-rate loans. That is, the interest rate stays the same over the life of the loan. For example, if you close on a 30-year mortgage at 6.5 percent in 2000, your interest rate will remain 6.5 percent in spite of how the market performs or what happens to the federal interest rate. This type of loan has been favored for decades because of its stability. However, variable rate mortgages (also known as adjustable rate mortgages or ARMs) have been rising in popularity. Variable rate mortgages typically start with interest rates lower than fixed-rate mortgages but may adjust up or down based on an index. In some cases, a variable rate mortgage could save you money.

Before pursuing a variable rate mortgage, it’s important to understand the advantages and disadvantages of both a fixed and variable rate mortgage.

Fixed-rate Mortgage Advantages

The principle advantages of a fixed-rate mortgage are simplicity and stability. The terms of a fixed-rate mortgage tend to be much simpler for consumers to understand. Unlike variable rate mortgages, which have numerous rules and caveats that determine how the mortgage interest rate is set, fixed-rate mortgages have the same general terms over the entire life of the loan. Fixed-rate mortgages are not sensitive to volatile real estate markets, which allows homeowners to budget several years in advance without any surprises. If interest rates skyrocket in 20 years, fixed-rate mortgage borrowers win because they locked in lower interest rates. Furthermore, if market conditions do drastically change, homeowners can often refinance a fixed-rate mortgage to take advantage of lower interest rates.

Fixed-rate Mortgage Disadvantages

Fixed-rate mortgages are almost always more expensive than variable rate mortgages upfront. Whether they remain more expensive than variable rate mortgages over the long run depends on a number of factors. As mentioned above, in a market with rising interest rates, fixed-rate mortgages save homeowners by locking in low rates. But in a market where interest rates dropped, a fixed-rate mortgage ties you into a higher interest rate unless you refinance your mortgage. The benefits of refinancing are offset by the costs of originating a new loan and hours spent consulting with a loan officer and shuffling paperwork. Depending on origination fees, pre-payment penalties and other factors, the costs of a refinance could actually negate the benefits.

An additional drawback of a fixed-rate mortgage is that they are willfully uniform from lender-to-lender. Mortgage lenders tend to sell fixed-rate mortgages on a secondary market, which gives less leeway for the lender to customize the loan for the borrower.

All in all, the benefits of a fixed-rate mortgage come down to timing. When interest rates are high, fixed-rate mortgages can be prohibitively expensive. Furthermore, taking advantage of dropping interest rates can be cumbersome. But in periods where interest rates are very low and the borrower intends to stay in the house for a long period of time, a fixed-rate mortgage is typically better.

Variable Mortgage Advantages

Variable rate mortgages are initially attractive for their lower upfront costs. Variable rate mortgages tend to have interest rates that can be an entire percentage point lower than a similar fixed-rate mortgage. Furthermore, many lenders offer discounted introductory rates or “teaser rates” that keep rates even lower. With the savings, variable rate mortgages can allow buyers to finance larger homes than they would’ve been able to afford with a fixed-rate mortgage. Variable rate mortgages are also ideal for markets where the interest rate trends lower. Borrowers with variable rate mortgages do not have to refinance in order to take advantage of lower rates, as their interest rate - and therefore their monthly payment - adjusts automatically.

Variable interest rate mortgages are particularly apt for those who do not intend to live in a home for very long. Interest rates rarely rise sharply, so an astronomically increase in interest rates is unlikely to occur within three to seven years. Plus, hybrid variable rate mortgages sometimes allow a fixed rate for a certain period (usually one, three or five years) at which time the mortgage reverts to a variable rate.

Variable Mortgage Disadvantages

Variable rate mortgages are far more complex than fixed-rate mortgages. Because of this, it is incumbent upon the borrower to carefully read the fine print and fully understand how their mortgages work. For example, some variable mortgages will only adjust upward - never downward. As a safeguard for consumers, many variable rate mortgages come with periodic or lifetime caps on interest rates. However, there are often numerous technicalities and loopholes that may work against the borrower’s favor.

The biggest and most publicized risk of a variable rate mortgage is price shock. Price shock occurs when the discounted or teaser rate expires, the interest rate rises sharply or an interest-only payment period ends and the borrower finds themselves paying much, much more for their mortgage than when they began. If the homeowner has not budgeted or planned properly for the higher costs, they can quickly end up in default or foreclosure.

Another situation that variable rate mortgage borrowers sometimes find themselves in is negative mortgage amortization. This occurs when the monthly payments are not enough to cover all of the interest due. Thus, the principle for the mortgage slowly grows, which causes the borrower to owe more than they initially took out when they first closed the loan.

In summary, the benefits of a variable rate mortgage come with a calculated risk. At the end of the day, you are essentially wagering that interest rates will remain steady or drop. There are a number of safeguards, caveats, rules and terms that adjust the parameters of this wager, but in most cases, these are structured to reduce the risk for the mortgage lender, not the borrower.

Conclusion

Savvy (or just plain lucky) consumers can save money by opting for a variable rate mortgage over a fixed rate mortgage. Variable rate mortgages, like all long term financial instruments, are highly complex and there is a lot to learn. We recommend reading some of our variable mortgage blog posts below to continue to educate yourself on adjustable rate mortgages:

Adjustable Rate Mortgage Essential Terminology