One of the most important decisions you can make with your mortgage is whether you go with a variable rate mortgage or a fixed rate mortgage. There are risks and rewards for both of them. Similar to most things money, the higher the risk the better the reward. This is the same with your mortgage.
A fixed rate mortgage is pretty simple. You choose a rate and term; your rate is locked in and remains the same for the whole term. If market rates go up or down during your term, nothing changes for you. Your term can be anywhere from 6 months to 10 years. Most people automatically go for a 5 year.
Advantages of a fixed rate term are that you know what your payments will be for the length of the term. You are not subject to interest rate increases causing you to pay more interest. This would be where you receive less rewards but much lower risk.
There are also a few disadvantages. If market rates drop, you can not take advantage of the lower interest rates. In many cases fixed rates are higher than a similar term variable rate mortgage. The biggest disadvantage is the way penalties are calculated for fixed rates. If you break your mortgage before your term is over you could face a penalty based on Interest Rate Differential or IRD. This calculation can lead to penalties much higher than variable rates.
With a variable rate mortgage your interest rate is tied to the bank prime rate. This is a rate set by your lender that they use for short term loans and revolving credit lines. Usually you would receive a discount off of prime as your actual contract rate. Example might be prime is currently at 3.45%. You get mortgage at Prime -1.00% or 2.45%. If prime goes up your rate goes up. If prime goes down your rate (in most cases) will go down.
The advantages of the variable are that you can take advantage of a much lower rate. Right now the difference between a 5 year variable and the best 5 year fixed is 0.89%. When you are dealing with thousands of dollars this can be a significant cost savings. The penalty is another advantage. If you break your mortgage the penalty is a 3 month interest penalty. Much smaller than an IRD. There are a few other advantages but these are the big ones.
The main disadvantage is that if rates jump up your interest rate goes up. This will increase the amount of interest you pay. Usually the increase is .25% when they do increase. There has only been 3 increases in the past several years and they all happened last year.
There are some great mortgage plans you can put in place to save you thousands of dollars on your mortgage interest. This includes taking a variable and using your prepayment options to pay your mortgage down faster. But this is a better conversion to have over trying to explain here.
Variable vs Fixed is definitely a personal choice to make. Variable is not for everybody but you can definitely save lots of interest by choosing one for your mortgage.
Your Mortgage Guru
This article is in the category: General.