Fixed Rate and Variable Rate Mortgages - What's the Difference?

As you apply for your next mortgage, you may be wondering if you should opt for a fixed-rate or variable mortgage. But, what's the difference? Is one better than the other? Can you save money either way? In this article, we'll cover the basics of both fixed rate and variable mortgages along with the benefits and disadvantages of each. Keep reading to learn more.

Fixed Rate Mortgage

A Fixed Rate Mortgage (FRM) is a home loan that is based on an unchanging interest rate. Basically, your interest rate is set and will remain the same throughout the course of your mortgage. So, if you obtain a mortgage with a 7 percent interest rate, you will retain that interest rate throughout the course of your 20 or 30-year mortgage.

One particular benefit of the fixed rate mortgage is that homeowners can budget for their monthly payments. Because the rate is fixed, so is your payment - meaning you can effectively budget and plan without worrying about fluctuating interest rates. For example, if you take a 30-year mortgage on a $300,000 home with a 6.5 percent interest rate, your monthly payments will always be $1896.20 per month.

Of course, because of the interest rate risk that the bank will have to take on, fixed rate mortgages can sometimes be slightly more expensive for the consumer. For example, a mortgage with a fixed rate may have a slightly higher interest rate than a variable rate loan. However, if interest rates rise, the fixed rate mortgage will always stay the same, thus saving you money.

Variable Rate Mortgage

A Variable Rate Mortgage (VRM), also known as a floating rate mortgage, is a home loan that bases its interest rates on the market, federal interest rates and market conditions.

Each month or quarter, your interest rate will vary depending on the rate issued by your bank and the federal government. Typically, the mortgage is directly linked to the standard index interest rate. But if this isn't dictated in the contract, then the rate can be adjusted at the lender's discretion.

Some lenders offer a cap-rate, meaning there is a maximum percentage on how high the interest rate can go. This is designed to protect borrowers against undue hardship in case of economic recession or soaring interest rates.

Overall, variable rate mortgages are often cheaper than fixed rate mortgages, but this isn't always the case. Basically, if rates go higher, so does the cost of the mortgage; and if rates go lower, the inverse is true. Essentially, the buyer has agreed to take on the interest rate risk which will typically result in a lower starting interest rate.

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