Variable Rate Mortgage
Why choose a mortgage with a variable interest rate?
With a variable rate mortgage, the amount of your monthly payments is usually fixed, but fluctuations in the interest rate can reduce or extend your amortization period. Mortgages with a variable interest rate are subject to fluctuations in the national prime interest rate set by Wall Street.
The interest owing on your variable rate mortgage will dip if the prime rate dips, but it will rise if the prime rate rises. Generally, if interest rates go down, more of your monthly payment will be applied to the principal on your mortgage loan. If interest rates rise, your money will go more towards interest than the actual outstanding balance.
Advantages of a Variable Rate Mortgage
The key advantage of a variable rate mortgage is that it tends to be less expensive than a fixed rate mortgage, at least over the long term. Lenders offer better interest rates on variable rate mortgages with the same period and terms as a fixed rate mortgage loan for an identical amount of money. This is because of a finance principle known as the "yield curve."
The yield curve is used to describe the difference in interest rates charged over the life of a short-term loan versus a long-term loan. Generally speaking, the shorter the term of the loan, the lower its interest rate will be. This is because fixing interest rates over the long term is inherently riskier; after all, what if interest rates head skyward and the bank is locked into a lower rate?
Thus, a discounted variable rate mortgage reduces the degree of interest rate risk the lender must undertake. Because interest rates often remain relatively stable for extended periods of time, many borrowers end up paying less, on the whole, over the life of a variable rate mortgage. As the borrower, then, your chances of saving thousands of dollars over the course of your amortization period is offset by the risk of potentially rising interest rates.
Variable rate mortgages are safest when interest rates are relatively high and expected to drop.
Disadvantages of a Variable Rate Mortgage
While your monthly payments won't fluctuate with a variable rate mortgage, an unexpected rise in interest rates can cost you thousands, or even tens of thousands, of dollars. Thus, variable rate mortgages can make long-term financial planning trickier because you never quite know when your mortgage will be paid off. A variable rate mortgage calculator is a valuable tool to help your planning, but the bottom line is that nothing will ever be 100 percent certain with a variable rate mortgage.
If you're prone to financial worry, or if you're in a tenuous financial situation, you might prefer the security of a fixed rate mortgage. However, if you have a moderate degree of risk tolerance and the potential of saving money appeals to you, a variable rate mortgage is a solid option.