Variable vs Fixed Rate Mortgages: Which is the Better Choice?

When researching mortgage options, consumers soon discover there’s a lot of information out there. There are so many choices when it comes to the type of home loan used when buying a home or refinancing an existing home loan. The most common decision might be whether to take a 30 year or a 15 year term. A 30 year rate will provide a lower monthly payment while on the other hand the 15 year term will result in less interest paid over the life of the loan. And let’s then say someone picks out a 30 year term and is then presented with a range of rates for the selected program. The next question might be how long the chosen interest rate needs to be guaranteed with a rate lock. There’s no shortage of decisions to be made when it comes to mortgages. Another common question is: Should I take a variable or a fixed rate loan?

Advantages of Variable Rate Mortgages vs. Fixed Rate

Historically, when rates are at relative highs, a variable rate might be the favorite choice and when rates are low, borrowers might elect to take advantage of low fixed rates for the long term. Today, fixed rates are still at relative lows while variable, or adjustable rates are slowly marching higher. Still, a variable rate might be the better choice, regardless of where fixed rates stand.

An adjustable rate mortgage, or an ARM, starts out with a lower rate, sometimes referred to as a “teaser” rate. These rates will be lower than a fixed rate but as the term “variable” clearly implies, it can and will change in the future. ARM rates are configured using an index and adding a margin to it. Today for example a common ARM index is the LIBOR, or the London Interbank Offered Rate. If the LIBOR rate is 2.00 for example and the margin is 2.00, the rate is then calculated at 2.00 + 2.00 = 4.00%. ARMs also have a feature called rate caps which helps keep the newly configured rate in check in somewhat volatile times… A cap might be 2% or 5% for example. Let’s say the cap on a particular ARM is 2.00% variance from the previous rate. If, one year from now when it’s time for an adjustment. Most ARMs also have an adjustment period of anywhere from six to twelve months.

Let’s now imagine the LIBOR index soared to say 6.00%. That won’t happen but let’s use this as an example anyway. Using the margin of 2.00, the new rate for the next year is 6.00 + 2.00 = 8.00%. But the loan has a rate cap of 2.00%, so while the “natural” rate, what lenders refer to as the fully indexed rate might want to go to 8.00%, it can go no higher than 2.00% from the previous rate.

One more twist? Today, many variable rate loan programs come in the form of a hybrid mortgage. A hybrid is an ARM that has an initial fixed rate such as three or five years. A hybrid has a lower start rate than a corresponding fixed but slightly higher than a 1-year ARM. At the end of the hybrid’s initial fixed rate term, it changes back into a loan that can adjust once per year.

Advantages of Fixed Rate Mortgages vs. Variable

Okay, but let’s not forget about a fixed rate, right? There really isn’t much to explain when it comes to fixed rate loans. The rate never changes, the only decisions to be made is the term of the loan and picking out a rate.

Variable vs Fixed Rate Mortgages: Which Comes Out on Top?

So which is better for you? Take a look at your current situation as well as down the road a few years. Do you see yourself moving or otherwise not having a mortgage in say five or seven years? If so, then a hybrid might be your better choice because the rate will be lower than a fixed. On the other hand, if you are longer term, you might consider taking out a fixed rate loan and locking in today’s rates. And of course, plans change. Someone might think of moving in a few years or paying off a mortgage rather quickly but then things change and it looks like a longer stay is in the picture.