This is a question every homeowner is faced with sooner or later. Your lender will offer (or try to sell you) a fixed or a floating rate mortgage and you will have to make a decision, a decision which might impact you for decades.
As a friend of mine just asked me how to think in this exact situation, I decided to share my response to him with you guys as I know he’s not the only one facing this question. In this post I intend to explain what the difference is and some of the key points to consider when deciding on a fixed or floating rate or a mix of the two when signing that mortgage paper!
Bear in mind that some countries have different rules in terms of personal guarantees on the mortgage, on payback schedule, early repayment penalties, when transferring the mortgage to another property etc.
I will try to be as generic as possible and as always, these are just my thoughts and ideas on this topic and before you make any financial decisions, you should always seek independent financial advise.
Let’s start with the basics of a Mortgage
Even if you haven’t yet bought your first home, I do believe you are familiar with the word mortgage and what it is. Still, I just want to make sure that you all follow and understand every aspect of this post as the impact it will have on your financial future is significant.
When buying a property (your home or an investment) you need to have the money to do so and most of us don’t have (or don’t want to spend) hundreds of thousands (or even millions) to finance a property purchase. That’s when a mortgage come into play. A mortgage is when you talk to your lender, often your bank, and ask for a loan with your property as the security. Your lender will do some calculations and look at the buyer’s financial situation (income, expenses, savings etc.) and the value of the property. Based on these factors they will come up with an amount they are happy to lend against that property.
The person who signs the mortgage (buyer of the property) will have to pay interest on the loan (x% per year) for the privilege of using the lender’s money to purchase the property. On top of that, they often require a payback plan of the loan which might mean that they want the borrower to pay it back over a period of 30-50 years. As you understand, this is a very long term commitment.
So a mortgage is basically the money you borrow to buy a property.
No, it’s not for free!
Well actually, based on all the money printing by central banks and the ultra low interest rates, the loans might actually become “free” in the future but let’s not go there and instead focus on what it most likely looks like for now.
When you borrow money from a lender, they don’t give you a loan just because you are a nice guy. They have their incentives and in this case it’s MONEY! They are lending you the money because they intend to make money on your purchase!
They do this by charging an annual interest rate. For argument’s sake, let’s say it’s 3%. So for every 100,000 USD you borrow, you will have to pay 3,000 USD every year in interest. This amount you will have to pay in infinity unless you are amortizing (paying off) your mortgage. If it remains at 100k forever and the agreed interest is 3%, you will be paying 3k every year but still have your mortgage. The lender might be happy with this as they will have your property as security. If you can’t or won’t pay, they will take your property and sell it to recoup their money.
They might charge other fees too like a mortgage arrangement fee and other payment fees etc. The interest you pay on your mortgage is the the one that’s likely to be there at all times and if you have your mortgage for 50 years, then the level of interest (how much you pay) will have a massive impact on your financial situation. This is why it’s so extremely important to understand how much you are paying and under what circumstances that can change.
Fixed or floating rate??
During the discussion with your lender they will ask/discuss floating versus fixed interest rate so let me explain the difference and some of my thoughts around these alternatives.
Floating rate (or variable) mortgage:
Floating rate means that the interest (cost) you pay for your mortgage will change over time and will be linked to a “benchmark”, often a rate from the central bank in one’s country. This means that if you have a floating rate today of 2,5% it can become much higher or much lower in the future, you basically don’t know. Fair enough, you can have a view on the economy and how your think the interest rates will play out but most don’t even want to be thinking about that.
In a simplified example: when the economy is doing well, the central bank is increasing it’s main interest rate to cool the economy down and this would mean that the interest you pay on your loan would increase. When the economy is doing poorly, the reverse would happen and central banks lower the interest rate and you should benefit by seeing lower interest on your floating rate mortgage.
This is currently the situation in most developed countries, loads of governmental stimulation and lower interest rates from the central banks and hence very low variable rates on mortgages!
Just remember, it can go the other way around too…
So with a floating rate, it will vary over time but often you have more flexibility if you would like to switch to another lender but again, this can vary depending on your lender and the jurisdiction you are in.
Fixed rate mortgage:
Fixed rate is exactly what is says, you get a fixed (pre-determined) interest rate for a certain period of time. This period could be anything from months to decades and sometimes even for the entire duration of your loan (30-50y).
By going for this alternative, you always know how much you will have to pay each month! The “drawback” historically has been the fact that it often turned out to be a more expensive alternative than going for the floating rate. The rule of thumb is that interest on a fixed mortgage is higher than floating even though there are exceptions.
Studies from many countries have shown that those who choose a floating rate pay less over the duration of the mortgage but they will of course also have to deal with fluctuations and sometimes very large fluctuations in the interest payments (most often paid monthly).
What about mortgage incentive rates or teaser rates?!!
Ok, teaser rates or a special/temporary rate is when you get an initial “discount” over a certain period. Let’s say you get an offer at 3,5% interest but there may be a teaser rate of 2,5% for the first two years. If you do your numbers solely on 2,5% you might delude yourself in terms of affordability as there will inevitably be more to pay every month after those two years.
I’m not against teaser rates as such, only when they are solely for the purpose of misguiding borrowers to take on loans they might not be able to afford over time. Teaser rates were partly to blame for the housing bubble that burst in the US around 2006-2008.
All I’m saying is just that one has to be very wary of what one is paying now versus later and the affordability to do so.
Pros with Floating Rate:
- Often a lower percentage than the fixed rate
- Over time, often the cheapest alternative
- If rates come down, you will pay even less!
- It’s easier to move your mortgage to another lender if they offer better rates (may vary by country/lender)
Cons with Floating Rate:
- Interest rates might go up and you will end up paying more than what you anticipated
- You don’t know the exact amount you will have to pay every month
- It might turn out to be a bad decision if rates go up and stay there, then a fixed rate might had been cheaper
Pros with Fixed Rate:
- You know the exact amount you will have to pay every month
- Easy to plan (no surprises)
- Currently at historically very low levels (cheap to borrow money even on a fixed term basis)
Cons with Fixed Rate:
- Often more expensive than floating over time
- If you want to transfer or repay your mortgage, you might have to pay significant amounts in penalties (interest compensation/redemption charge). This point is extremely important as it might handcuff you for decades and impact your quality of life!!
- You have no idea where the interest level on floating and fixed will be next time you will need to re-finance (when the fixed rate term is over). It might mean when your 5y fixed mortgage comes to an end, floating might be very high and fixed rates even higher! So in this case you have a re-financing risk unless you have already paid off your loan by the end of that fixed rate period. They don’t always have to match as you can have a 30y mortgage and part of the mortgage on floating rate and part on a 5y fixed term which will need to be re-financed after that 5y period.
Let me just give you an example of the above. Say that you are borrowing as much as you can and this comes to 500k and you take a fixed mortgage for 30y with an interest rate of 3,5%. What if you 1y later find your dream home which is 600k and your current lender will not increase your mortgage (you basically have to find the 100k) and you are stuck with them for 30y!
If another lender would be happy to lend you 600k, you wouldn’t even have to find the additional 100k as a lender would offer you the full amount you needed. The problem then is that repaying your old mortgage with the new one might mean severe redemption penalties! Instead, had you been on a variable interest rate then maybe (again depending on your country and lender) you could possibly have repaid the old mortgage with the new one and get away with minimal fees!
Also, if you are on fixed terms, your negotiation power to lower the interest rate is basically non-existent and the same goes for all of your dealings with that lender. If you are tied to them, your negotiating power is limited and threatening to move to a competitor will be ignored as you are very unlikely to do so since it would come with such hefty penalties.
What you do completely depends on your situation but you have to understand the difference between the two so that you can assess your own situation! Personally I have had to pay early redemption fees and because of that, I’m very reluctant to take on a mortgage with a fixed interest even if it’s nice knowing how much one has to pay every month (in Sweden there might not be early redemption fees per se but you have to pay an interest differential if you repay a fixed mortgage early).
Being tied to one lender and having basically no negotiating power is not a good thing in my eyes. If competitors lower their floating rate, one can always negotiate but not so much if the lender knows you are bound to them because part of your mortgage is fixed and there are heavey penalties to move.
If you are having a hard time taking good care of your finances or if you often worry about money, maybe it would feel a lot better if you had a fixed mortgage, knowing exactly what you have to pay every month and no fluctuations. This in contrast to the person who feels more comfortable with their finances and the language of money and understands that over time, floating rates have been the cheapest alternative even if those rates have been very high at times!
I prefer financial flexibility even if it occassionally might come at a cost but again, it’s completely individual although I hope I have managed to put some clarity on the concepts of fixed and floating rates and when they might be suitable and the potential consequences of one over the other.
Actions to take:
- Check your mortgage and understand what your agreement says!
- Always use Leverage – wisely!
- How the economy works – to understand when your mortgage cost is impacted and why!
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