When buying a home, we will have to decide between a fixed mortgage or a variable mortgage. Each of them has its advantages and disadvantages. We analyze both fixed and variable rate mortgages, so you can take an informed decision.
- Variable Rate Mortgages
- Fixed Rate Mortgages
Interest rates in the 2020s are much lower than they have historically been. While the all-time lows seen a couple of years ago are probably a thing of the past, we can still expect financing to remain relatively cheap.
What has increased in the last few years has been uncertainty regarding monetary policy. This has led to an increase in interest volatility, impacting home buyers who have to choose whether they will take a fixed or variable mortgage.
Some home buyers have favored something in between by taking an ARM or a mortgage with a similar structure, thereby fixing the interest rate for a period of several years before it resets.
In the next few sections, we will analyze the advantages and disadvantages of both fixed and variable rate mortgages:
Variable Rate Mortgages
A variable rate mortgage tracks a benchmark interest rate index such as Fed Funds in USD, Euribor in EUR, or the BOER in GBP. These interest rate indexes fluctuate constantly. A variable rate mortgage will observe the value of the benchmark index at regular intervals and reset the applicable interest rate for the mortgage borrower.
Variable mortgages also have a spread over the benchmark interest rate index. For example, a variable interest rate mortgage may have its interest rate as the Bank of England rate plus 1%, reset every 6 months.
Therefore, if the BOE rate is 4% at the time of reset, an interest rate of 5% will apply for the following 6 months. 6 months later, if the BOE rate is at 3.5%, the mortgage interest rate will get adjusted down to 4.5%.
Such a mortgage has its advantages and disadvantages:
Advantages of a Variable Rate Mortgage
The great advantage of variable mortgages is that they are usually cheaper in the long term. There are many reasons for this, but the most important one is that longer term interest rates are usually higher than shorter term interest rates. The relationship between variable and fixed interest rates is analyzed in this post.
In addition, with a variable rate mortgage, we have the potential to benefit from lower interest rates in the future. This could happen in times of economic recession, thereby cushioning the reality of a worse labor market for mortgage borrowers.
The other advantage of variable mortgages is that they usually have fewer commissions. Whether we are taking about the product fee or potential early repayment charges, variable rate mortgages tend to have less fees.
Disadvantages of a Variable Rate Mortgage
The big disadvantage of variable rate mortgages is that they have more risk. A variable rate mortgage exposes us to higher monthly payments if interest rates rise in the future.
Such increases in the monthly payment can be substantial if there is an interest rate shock in the markets like the one experienced throughout 2022 and 2023. The rapid interest rate hikes by central banks during this period led to many variable rate borrowers having to make much larger mortgage payments.
The other disadvantage of variable rate mortgages is that the interest rate for the first 12 or 24 months is usually higher than what the variable rate would be. That is a way for banks to hide their fees when granting a mortgage.
Fixed Rate Mortgages
Fixed rate mortgages have the same interest rate for the entire duration of the mortgage loan. This means that if we take a 30-year mortgage with a 5% interest rate, we know how much interest we will payment over the next 30 years.
Advantages of a Fixed Rate Mortgage
The great advantage of fixed rate mortgages is that they have less risk. Because the interest rate is fixed for the entire duration of the mortgage, we know in advance how much our monthly payments are going to be. And these payments will never change.
For those fortunate enough to have taken fixed rate mortgages a few years ago, monthly payments did not change when central banks hiked interest rates in 2022 and 2023.
For example, in the United States some people were able to get 30-year mortgages at interest rates close to and even below 3%. In Europe, financing was even cheaper.
Some people in the Eurozone were able to borrow at close to 0% interest for periods of between 10 and 25 years. Similarly, some borrowers in the United Kingdom could get financing for periods of between 5 and 10 years with an interest rate close to or below 2%.
Disadvantages of a Fixed Rate Mortgage
The big disadvantage of fixed rate mortgages is that they are more expensive in the long term. All other things being equal, the fixed interest rate is more expensive than the variable rate. This has to do with the structure of the interest rate market where longer-term interest rates usually trade at a premium relative to short term rates.
Another reason why fixed rate mortgages are more expensive is that they tend to have higher fees. Both the origination fee and the early repayment charges could be higher. The higher early repayment charge is in place to protect the lender in case we want to repay our mortgage early because interest rates have moved down significantly since when we took the mortgage.
As you can see, the choice between a fixed rate or variable rate mortgages can be reduced to one single sentence:
Variable rate mortgages are usually cheaper but have more risk. Fixed rate mortgages tend to be more expensive but are also a safer choice.
Thus, the decision comes down to what your risk appetite is as well as your ability to take on that higher risk. If you want to be conservative, the fixed rate mortgage is probably the best option for you.
On the other hand, if you have a strong financial position, want to maximize your expected wealth, and would be able to face potentially higher mortgage payments in the future, the variable rate mortgage is probably your best bet.
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