What is the Difference between a Fixed Rate and a Variable Rate Mortgage

The difference between a fixed rate mortgage and a variable rate mortgage is essentially that a fixed rate mortgage has a single fixed interest rate that is determined at the time of loan approval or underwriting while a variable rate mortgage does not. A fixed rate will not change over the entire term of the mortgage whereas a variable-rate mortgage allows the bank to adjust the interest rate over the term of the mortgage. This usually ocurrs by updating it to follow changes in the bank’s prime rate. There are potential advantages and disadvantages to each of these.

Fixed rate mortgages are in some ways the simpler of the two. Financial writer Bruce Schoenne explains that a fixed mortgage is “a mortgage where the rate of interest is fixed for a specific period of time”. At the time a mortgage is given, the bank determines an interest rate based upon a number of factors including the number of years over which the mortgage will be repaid, the credit rating of the new homeowner and the typical interest rates in the market at the time. The interest rates will be based upon a central rate determined by the bank, called the “prime rate.” In a fixed-rate mortgage, this interest rate will be fixed over the entire term of the mortgage.

Fixed-rate mortgages may be best for people who fear that interest rates will go up in the future, or are simply not sure what interest rates will do in the future and are unwilling to gamble that the rates will change in their favour. In the case of a fixed-rate mortgage, instead of the home buyer gambling that interest rates will change in their favour, the bank is gambling that it’s better to loan out its money at a fixed rate now than to wait for markets to change in the bank’s favour later on. For this reason, fixed rate mortgages may be harder to get initially, and may have a higher initial interest rate (and therefore higher monthly payments) than a variable rate mortgage. The advantage to the home buyer is that while the payments may initially be higher, this type of mortgage offers the security of knowing that the rates will at least never get any higher.

In contrast, Schoenne says, a variable rate mortgage is “a mortgage that has fixed payments, but the interest rate fluctuates with any changes in interest rates.” In this case, the bank will still determine an initial interest rate for the mortgage based upon the prime rate, the home buyer’s credit rating and the expected duration of the mortgage. However, the mortgage agreement will also specify a regular period of time after which the bank is allowed to reassess the interest rate and move it up or down in accordance with changes in the prevailing market interest rates.

Variable-rate mortgages may be useful for those who are willing to accept a certain amount of risk up-front in exchange for the possibility that they will save thousands of dollars in interest later on. In 2001, York University professor of finance Moshe A. Milevsky examined mortgage interest rates between 1950 and 2000 and concluded that, on average, homeowners pay less interest over the term of their mortgage if they choose a variable rate rather than a fixed rate. The key is the level of risk that homeowners are willing, and financially able to take. This is because just as the interest rate could go down, it could also go up – a phenomenon called payment shock. “Long-term stability has a price,” says Schoenne, “but if you can’t sleep, what good is the money?”

If you are not sure whether a fixed interest rate or a variable interest rate is right for you, a financial advisor will be able to give professional advice tailored to your specific situation.