When buying a home, most of us will need to take out a mortgage. For many, this long-term loan will likely be the most significant sum they’ll ever borrow. So, it’s essential to ensure you take out the best loan for your circumstances.
Mortgages come in all shapes and sizes, and picking the right one can be tricky. Fortunately, with a bit of know-how, you’ll soon be able to tell a fixed-rate mortgage from a variable or adjustable-rate one.
In this guide, we’ll take an in-depth look at the three main types of mortgages available to you:
Understanding Mortgages: The Basics
A mortgage is a long-term loan that enables most people to buy a house. While you’ll still need to pay a down payment, the bulk of the home’s value will be covered by your lender. You simply have to make regular repayments (typically monthly) until you’ve paid off the full loan value.
However, since they’re taking a considerable risk in lending you such a substantial amount of money, lenders will also charge interest to gain something from the transaction. This ensures that they earn back what they’ve loaned you, and some, by the end of the amortization period — the time it takes for you to pay off the entire loan value.
This period is broken up into smaller terms, typically lasting between six months and ten years. Terms generally need to be renewed several times during the amortization period, and there are three main types of mortgage terms to choose from:
- Fixed-rate mortgage
- Variable-rate mortgage
- Adjustable-rate mortgage
What Are Interest Rates?
Before you choose a mortgage type, it’s essential to have at least a basic understanding of what interest rates are and how they work. Interest is basically the price you pay to borrow money and is a percentage of the total amount you’ve borrowed.
Several factors, such as the state of the economy, can cause interest rates to fluctuate. Interest rates are set by a country’s central bank — the Federal Reserve in the U.S. and the Bank of Canada in Canada. When the central bank sets the market rate higher, borrowing costs more.
Calculating Interest on Your Mortgage
Your individual risk as a borrower will also affect the interest rate you’ll be offered on a mortgage. A higher credit score will generally result in lower interest rates, while a lower score will see you paying more interest.
With a mortgage, you’ll typically be charged an annual percentage rate (APR). This figure is determined by the lender based on the central bank rate and your credit score.
For example, if you take out a $300,000 mortgage with a 4.5% APR, you’ll be required to pay $13,500 in annual interest, split across your monthly repayments. On a 25-year mortgage, that can add up to $337,500 of interest plus the original $300,000.
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What Is a Fixed-Rate Mortgage?
As the name suggests, this type of loan enables you to lock in the interest you’re required to pay for the entire duration of your term.
For example, if you take out a ten-year term with an interest rate of 4%, you’ll pay 4% interest on each and every repayment, even if the market rate rises and your credit score drops.
The Benefits of a Fixed-Rate Mortgage
The biggest advantage is that you know the exact amount you will be required to pay each month, making it much easier to set a monthly budget and stick to it.
Plus, you don’t have to worry about your repayments increasing over time due to rising market interest rates. Even a 1% rise can increase your monthly payments by upwards of $100 overnight, something you might not be ready for.
The Disadvantages of a Fixed-Rate Mortgage
One of the most significant drawbacks of a fixed-rate mortgage is that you can end up paying more in interest than you would with other types. This is because lenders tend to set higher rates on their fixed-rate mortgages than the market rate.
So, if the market rate drops, you’ll be locked into a deal that sees you paying a higher rate for the duration of your term.
Another potential disadvantage of a fixed-rate mortgage comes when you might have been enjoying lower rates compared to the market for several years. If, when your term ends, the market rate has seen a sharp increase, you could find that your repayments have suddenly ballooned when you renew. This can play havoc with your budget and be a real struggle to keep up.
When to Take Out a Fixed-Rate Mortgage
Choosing a fixed-rate mortgage comes down to a mix of your lifestyle and understanding the market. If the peace of mind offered by a fixed-rate mortgage means you won’t lose sleep at night worrying about your repayments rocketing, it’s a top choice.
The best time to take out a fixed-rate mortgage is when market interest rates are low, and your credit score is high. When the market rate is low, it will only drop so far, so it’s more likely to rise in the future. As a result, your fixed-rate mortgage will be better protected against market swings. Combined with a great credit score, you can find some great deals.
What Is a Variable-Rate Mortgage?
Fixed-rate mortgages are among the most popular types taken out by borrowers in both the U.S. and Canada. However, while they offer stability, they’re not always the best choice. A variable-rate mortgage can be a fantastic alternative.
While a fixed-rate mortgage locks in your monthly repayments for the duration of the term, the interest paid on a variable-rate mortgage fluctuates with the market rate. This can be great news if the market rate drops, but it can work against you if it experiences a sudden increase.
When interest rates are low, you can pay off more of your mortgage and reduce your amortization period. If rates rise, you’ll pay more interest each month.
The Benefits of a Variable Rate Mortgage
The main advantage of taking out a variable-rate mortgage is that the total amount of interest you’ll be required to pay may be lower than with a fixed-rate mortgage. Variable-rate mortgages may begin with lower repayments than fixed-rate mortgages — saving you money, at least for a while. In favorable market conditions, variable rates will remain low and may drop even further, while fixed rates will remain the same.
During periods of low interest rates, you’ll be able to pay off more of your mortgage, reducing your amortization period considerably.
The Disadvantages of a Variable-Rate Mortgage
However, interest rates can rise sharply in a short period of time. If this happens, you’ll need to pay more and more each month in interest until things settle down.
You need to be prepared for increases, which can put financial strain on a tight budget. This requires planning and ensuring you have a buffer zone. It can be stressful watching interest rates creep up, and if you’re the kind of person who would lose sleep at night worrying, a variable-rate mortgage might not be the ideal choice for you.
Making the Most Out of a Variable-Rate Mortgage
You might be tempted to go for a variable-rate mortgage when rates are at an all-time low. However, this may not be wise, as there’s a higher chance they will rise rather than fall in the future. A good rule of thumb is that if there is no more than a 1% difference between a variable and fixed-rate mortgage, it’s wise to go for the latter.
It’s also a good idea to not just make the minimum monthly repayments if you do choose a variable-rate mortgage. Set your payments to the same rate as current 5-year fixed rates. This provides a buffer zone in case rates rise and can also help you pay your mortgage off quicker if rates remain low.
Thorough research and planning are necessary to make a variable mortgage work. Still, if you expect an increase in income or can already comfortably pay the minimum payments, a variable-rate mortgage could be the choice for you.
Image: Puttachat Kumkrong / Shutterstock.com
What Is an Adjustable-Rate Mortgage?
An adjustable-rate mortgage is a type of variable-rate mortgage, and it works similarly. It differs in that you’ll be offered a fixed introductory rate that is typically very appealing to borrowers. This fixed rate can last as little as a month or as long as ten years, enabling you to save money when needed most — at the beginning of your mortgage journey.
The Benefits of an Adjustable-Rate Mortgage
The introductory rate will always be lower than a fixed-rate mortgage, usually by at least 1%, often more. An adjustable-rate mortgage can work extremely well for homeowners looking to take advantage of low rates and perhaps intend to move house after a few years or who expect to earn much more in the future.
The Disadvantages of an Adjustable-Rate Mortgage
As interest rates rise, so do your monthly repayments once the introductory period has ended. No one can be 100% certain which direction the market will go. This makes an adjustable-rate mortgage more of a gamble than other options and can make it difficult to budget accurately.
Interest rates can rise quickly and unexpectedly, and if you’re on a tight budget, you might not be able to cover the additional cost comfortably. This uncertainty can be stressful if you don’t have an adequate buffer zone, and missed payments can lead to foreclosureWhat is foreclosure? Foreclosure is a legal process by which lenders acquire a title to... More.
Making the Most Out of an Adjustable-Rate Mortgage
Adjustable-rate mortgages are typically favored by homeowners focusing on the short to medium-term. In particular, investors planning to sell before interest rates increase too much tend to be attracted to this option.
However, a lot depends on the market rates, paired with the length of the introductory rate period. Whether the lender enforces penalties for early payment should also be considered.
It’s not such a good choice for those on a tight budget. While the low introductory rates may be attractive, once the initial period is over, the monthly payments can rise considerably depending on the market. If you can’t afford to pay extra comfortably, it’s better to go with a more stable, fixed-rate mortgage.
