Fixed Vs Adjustable Vs Variable-Rate Mortgages- What's the difference?

Choosing the right mortgage type is one of the most important financial decisions for homebuyers. With various options like fixed, variable, and adjustable-rate mortgages, understanding how each works and their potential benefits and risks is essential.

1. What is a Fixed-Rate Mortgage?

A fixed-rate mortgage means your interest rate remains the same throughout the loan term. Your monthly payments are predictable, making it easy to budget. Typically your rate may be a little higher for a fixed rate as the lender builds in a buffer for interest rate fluctuations.

Pros:

• Predictability: You’ll always know what your monthly payments will be.

• Protection from rising rates: If market rates increase, your rate stays the same.

• Long-term stability: Fixed rates offer peace of mind, especially for risk-averse buyers.

Cons:

• Higher initial rate: Fixed rates are generally higher than variable rates at the start of the mortgage term when interest rates are stable.

• No benefit from falling rates: If market rates drop, you won’t see a decrease in your interest unless you refinance, which may incur penalties.

• Interest Rate Differential (IRD) penalty: If you break your mortgage early (to refinance, pay it off, or sell), lenders will charge you either a 3 month interest penalty or an IRD (whichever is higher). An IRD is essentially the difference between the interest they were going to collect from you for the remainder of your term and what they say they can lend your money at for an equivalent period. The math here deserves it's own blog post, but suffice it to say this could cost someone thousands of dollars extra.

  
  

2. What is a Adjustable-Rate Mortgage?

An adjustable-rate mortgage has an interest rate that fluctuates with market conditions, typically tied to the lender’s prime rate. Your payment amount can change over time based on how the rates move. Most adjustable-rate mortgages provide the option to lock into a fixed rate later, should you change your mind. They are often also called change payment variable rate mortgages. What matters is you confirm if your payment will change with interest rates.

Pros:

• Lower initial rate: Adjustable rates are often lower than fixed rates at the start of the mortgage.

• Potential savings: If interest rates fall, your payments decrease.

• Lower prepayment penalties: Because your interest rate is always the market rate, your prepayment penalty will almost always be 3 months interest.

Cons:

• Payment uncertainty: Your payments may increase if interest rates rise.

• Increased risk: This option may not be ideal for those who prefer financial predictability.

  
  

3. What is an Variable-Rate Mortgage (VRM)?

A variable-rate mortgage (VRM) is a hybrid between fixed and adjustable rates. While the interest rate will fluctuate with market conditions, your payment will generally remain the same. This means if rates go down, you will pay off more of your mortgage with each payment. If rates go up, you will pay more interest, and therefore less principle with each payment. Most variable-rate mortgages provide the option to lock into a fixed rate later, should you change your mind.

Pros:

• Lower initial rate: VRMs generally offer lower interest rates than fixed-rates at the start of a mortgage.

• Flexibility for short-term ownership: If you plan to sell or refinance before the rate adjusts, you can take advantage of the low initial rate without worrying about future rate increases.

• Lower prepayment penalties: Because your interest rate is always the market rate, your prepayment penalty will almost always be 3 months interest.

Cons:

• Rate increase risk: If rates increase, your amortization may be affected.

• Trigger rate: If your interest rate ever increases to the point that you owe more interest in a month than you are paying, your payment will be increased to cover the shortfall.

  
  

4. Comparing the Three Options:

Feature	Fixed-Rate Mortgage	Adjustable-Rate Mortgage	Variable-Rate Mortgage
Initial Rate	Usually higher than variable or adjustable	Typically lower than fixed-rate mortgages	Typically lower than fixed-rate mortgages
Interest Rate Changes	Never changes	Fluctuates with market rates	Fluctuates with market rates
Payment Stability	Stable throughout the loan term	Can change based on rate fluctuations	Usually stable throughout the term
Risk Level	Low: Predictable and stable payments	High: Payments can increase or decrease	Medium: Usually predictable and stable payments.
Best For	Buyers who want long-term stability	Buyers comfortable with risk and rate fluctuations	Buyers who want the best of both worlds

5. How to Decide Which Mortgage is Best for You

Choosing the right mortgage depends on several factors, including your financial goals, risk tolerance, and the current interest rate environment. Here are some guidelines to help you decide:

• Fixed-Rate Mortgage: Ideal for homebuyers who prioritize payment stability and plan to stay in their home for a long time. If you expect interest rates to rise or prefer predictable payments, this is a solid choice. Consider if you are a first time homebuyer or purchasing with a tight budget. Also a good option for rental units due to the predictability of cash outflows.

• Adjustable-Rate Mortgage: Suitable for buyers who are comfortable with uncertainty and want to take advantage of potential savings when interest rates will decrease. If you expect rates to remain steady or decline, this option can be beneficial. Historically, adjustable rate has been the winner when it comes to minimizing interest costs. With lower prepayment privileges, adjustable rates are great options to with if your mortgage is with a big bank, as you can remain more flexible.

• Variable-Rate Mortgage: Ideal for those who want the best of both worlds. This options provides stability in payments while benefitting from the historic savings associated with adjustable rate mortgages. It also provides the flexibility of adjustable rates.

Conclusion: Consider Your Financial Situation and the Market

Choosing between a fixed, adjustable, or variable-rate mortgage depends on your financial situation, how long you plan to own the home, your comfort level with potential rate fluctuations, and your reason for your purchase. The current state of the economy, inflation, and central bank policy can also affect your decision. Consulting with a mortgage professional can help you determine which option aligns with your goals.