Buying a home: what an exciting time! It might be simpler if mortgages were one size fits all. It would be nice if you knew you would get approved, that you would get the best interest and repayment terms because there was only one type. Like, you know ahead of time that you will go in and apply, get approved for a 15 year mortgage at 3% interest, and so on. You know what you are getting into, you know the common words that are thrown around with mortgages, you know exactly what your contracts mean and all so there is absolutely no confusion.
Yes, I know, it would be wonderful. Unfortunately, it just is not real. There are so many different terms and factors and rates and everything when it comes to mortgages, and interest rates is a major thing that changes depending on so many factors. That, my friends, is going to be our discussion for today. Among other important mortgage information, we are going to have a talk about fixed versus variable rate mortgages. Why? The one you choose can have a major impact on every other part of your mortgage. Choosing the best one for your bank account and lifestyle is beyond important.
Fixed Versus Variable Rate Mortgage: The Basics
Of course, in order to talk about these different types of mortages, we need to make sure you know the basics. In the next couple of sections, I’ll define fixed and variable rate mortgages, compare them and talk about pros and cons of each. So here we go.
Fixed Rate Mortgage
A fixed rate mortgage means that the interest rate will stay the same throughout the entire mortgage term. This means that if your rate is for example 5%, it will stay like that forever. You will see the change in the payment every month, but not because the interest rate changed. It is because the principle amount owed decreases over time. Let’s see an example of a so called amortization. means that each mortgage payment you make puts some towards the interest and some towards the principle. In the beginning, your monthly payments pay a high amount of interest with little going on the principle. However, as the principle decreases, so does the interest, meaning that with every payment pays more to the principle than the last payment.
To Interest $416.67
To Principle= $120.15
To Interest= $416.17
To Principle= $120.66
To Interest= $415.66
To Principle= $121.16
Month 6: (Skipping Ahead)
To Principle= $122.68
Month 9 (Skipping Ahead)
To Interest= $412.60
To Principle= $124.22
Month 12: (Skipping Ahead)
To Interest= $411.04
To Principle= $125.78
As you can see, your payment stays the same, but how it is split changes. The amount will continue to shift until your very last payment. It is important to note that the interest rate remains at 5% the entire term.
Variable Rate Mortgage
In most cases, if you try to look up what a variable rate mortgage is, your head will start to swim. The explanations can get crazy, which is crazy in itself. It is not really that bad. Like a fixed rate mortgage, a variable rate mortgage has set payments. To keep everything simple, we are going to use the same payment information as in the amortization example above, making the monthly payment $536.82.
The difference is that the interest varies according to market fluctuations. You are still paying the same $536.82 every month, but the amount of that which is put towards the principle depends on the market. Where the fixed rate mortgage meant the interest was determined according to the fixed 5% interest rate and the amount of principal you owe, it can get a little crazier with the variable rate.
Let’s put it like this: With a variable rate mortgage, if the market interest rate is only 2%, then more of your monthly payment is going to your principal. If the market interest rate goes to 6%, less of your monthly payment goes to your principal.
How Come The Interest Rates Can Change?
If you are wondering how do banks set the rate at which they give loans, here it is. The interest rates depend on the Federal funds rate. The Federal Reserve determines the periods where they either tighten or ease the Federal funds rate. So naturally, when you are looking to buy a home and get a mortgage, timing is everything. If you are looking for a fixed rate mortgage, it is crucial that you get the mortgage during the period where the Federal funds rate is low. Because once you set the rate, it stays like that forever. However, if you are looking to take out a variable rate mortgage, it will change according to what we just mentioned.
Variable Rate Mortgages and Adjustable Rate Mortgages are Not the Same
As if fixed versus variable rate mortgages are not confusing enough, there is another term to throw into the mix. Let’s go ahead and get it out of the way: Variable rate mortgages and adjustable rate mortgages are two separate things. An adjustable rate mortgage is a type of variable rate mortgage, but the terms are not mean to be interchangeable. Adjustable rate mortgages mean that the borrowers payment fluctuates according to the market interest rate.
A variable interest rate mortgage- unless specified otherwise- keeps the payment the same. Sometimes, though, depending on the contract, the payment with a variable rate mortgage only keeps the payment the same for a certain number of years, so be sure you know what you are signing up for.
Fixed Versus Variable Rate: Pros and Cons
So what are the clear cut differences between a fixed versus variable rate mortgage? Now that we have gone over all of this information, let’s see if we can tie it all together with a nice little bow.
When it comes to choosing between fixed versus variable rate mortgage, there is one thing to know: you have to consider the pros and cons according to your life and make up your own mind.
Variable Rate is Historically More Beneficial
Up to this point, variable rate mortgages have charged less interest over the life of the loan. This tends to make new borrowers decide to go with variable rates, but it is important to note that history does not decide the future. Just because it has charged less in the past does not necessarily mean that it will charge less in the future.
Another pro is that this type of mortgage is much more flexible. You can decide to pay more every month, or even pay the mortgage off earlier, but you don’t have to worry about the penalties as with other types of mortgage.
Fixed Rate Mortgages are More Predictable
With a fixed rate mortgage, you know how much interest and how much principle you will be paying every month. In fact, your lender might have even printed you off a schedule. You know when your last payment will be and you can literally count down until that moment. And you can even much more easily make a plan to pay your mortgage off early. You can determine how much faster you can pay it off if you pay just an extra $5 per month.
This is not so easy with variable rate mortgages. Sure, you can take a look at current market rates each month and decide what to do, but you cannot make a progressive plan ahead of time. With all of the fluctuation in the market, the best you could probably do is a month to month plan, but that might not even be foolproof considering that daily mortgage rates change.
Consider the Cons As Well
We talked about the pros, but there are also cons. With a variable rate mortgage, you never know what could happen. Yes, the rate just might go down, but there is a chance that it goes up as well. This is a very important thing you should be aware of. You can benefit greatly from a variable rate, but you might also have less luck during your 20/30-year term.
On the other hand, a fixed rate mortgage rate does not change, but if the rates drop, you have no way of benefiting from that. Your rate is fixed, and it stays the same no matter what happens. It is also pretty difficult to increase the amount you pay every month without any penalties. So if you think you will somehow get a larger amount of money in the future, you would want to leave the option of repaying your mortgage earlier open (or at least paying more each month).
The fact of the matter is that if you wish to make any type of plan for the future, it is best to choose a fixed versus variable rate mortgage. If you are okay going with the flow, a variable rate may be the better choice.
Choosing Between Fixed and Variable Rate Mortgage
As with most financially related stuff, there is not a single answer to this question. It largely depends on several factors. You should ask yourself whether you appreciate stability and predictability more than potentially paying less in interest over time if it drops. But you should also ask yourself whether you will be able to handle increasing of rates if you choose a variable rate.
Some other things to consider are whether you will want to pay off the mortgage earlier if you get the chance, or maybe increase your payments. These two things are more difficult to do with a fixed rate mortgage. You can also think about whether you love the terms of a fixed mortgage and if you will be able to stick to them, then this may be the right option for you. Finally, if you are considering to switch mortgage one day, you should definitely look into a variable rate one, since it not possible or very expensive when you have a fixed rate mortgage.
The Mortgage Process Including Fixed vs Variable Rate
Have you ever applied for a mortgage? If you have not, you may be surprised to know the entire process of applying, getting approved, and closing the deal can take months. The average, when everything goes at least somewhat according to plan, is three to five months. I say this not to burst any excitement bubbles, but for three reasons:
- To set proper expectations.
- To make sure you know that you have time to step back and really make sure you are making good choices with your mortgage loan shopping.
- Also to let you know to take your time and do your part as well as possible to prevent adding extra time to this timeline.
Now that you know what fixed and variable rate mortgages are, their similarities and differences, let’s describe the mortgage process so you know what to expect.
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Step 1: Get Ready for a Mortgage
Really….if you are buying a home with a mortgage, you need to prepare for it. This should start with a look at your credit report. What type of rates will your credit get you? Of course, you will not know this until for certain until you get offers, but you can get an idea. The best rates usually go to those with a credit score of at least 750.
Sometimes, you can find good terms for lower scores, but it takes some real rate shopping to find them, so take a good look around and do not settle for the first mortgage lender you locate. In fact, getting preapprovals from a few lenders is a really good move to compare.
This is the moment where you should decide whether you want a fixed, or a variable rate mortgage. Take a dive into your financial situation and decide what seems best for you and your family. If your kids will be moving out in ten years and you and your spouse plan on downsizing at that time, a variable rate mortgage that you can pay off earlier may be a good fit for you.
After you have an answer solidified on that, consider your down payment. How much can you put down to help lower your mortgage? Really think about this. If you must, find a way to increase your down payment. Remember- the less you borrow, the less you pay interest on, which should always be a goal. Whether the interest is fixed or variable, it is always best to borrow as little as you can.
Now, you can start looking into mortgage lenders a little deeper and put in official applications. You will get either a rejection or preapproval. The good thing, though, is that if you are rejected, you can ask what you can do to get approved. Often, lenders can give you some pretty good and clear suggestions since they have actually taken a look at your credit. Hopefully, though, you will be approved and get to move to the next step.
Step 2: Find Your Home
Sorry, the work is not over- it has just begun. You now have to find a home that meets your needs and wants within your loan amount and price range. This is done more easily with a real estate agent, but do remember that there may be extra fees included with hiring a real estate agent. Most often, they will be included in all of your home buying negotiations/closing costs, so nothing should be coming out of pocket. When you find the right home, you make an offer.
Step 3: Get the Mortgage
If the seller accepts your offer, it is time to get to the nitty-gritty. It is time to finalize the mortgage and all the details it involves- including but not limited to choosing between a fixed versus variable rate mortgage- get the home inspected and appraised (the costs of which are usually included in the closing costs), negotiating, and anything else that may need to be done.
In this step, Loanry maybe can help you to make all process a little bit easier. All you need to do is to enter your information and see whether you could be paired up with lenders which may make you an offer within next couple of minutes. You can start here:
Step 4: Wait
You are pretty much done, but you have to wait on the lender to finish its process, which means the underwriting process. They will verify everything, ask you for any additional documents, and so on. When they have finalized their approval, you finish signatures and make your down payment and close the deal. Whew! It took a lot of work, but you are now in your new home. All you need to do now is enjoy it and make your mortgage payments, which is why choosing the right mortgage and interest rate is so important. You do not want the wrong choice to cause you to lose the home you worked so hard for.
I hope that this guide has helped you get a good understanding of common mortgage terms and what it means to choose between fixed versus variable rate. When you do get your hands on your dream home, I want you to be able to hang onto it. Look through this guide as often as you need to feel confident in your decisions and, of course, do not forget to consult your financial advisor if you need to discuss your situation specifically. Be sure you take your time with all of your rate shopping and decisions. This is a commitment, so do not rush until you feel confident about your decision.