Have you ever wondered which one is better: a fixed or variable rate? You might think that a variable interest rate is the best option always, given that a variable interest rate is one that is variable, meaning that it can change over time.
A fixed interest rate, on the other hand, does not fluctuate over time. You’re locked in.
We often talk about variable and fixed interest rates when we talk about loans. A loan is a debt provided by one organization or individual towards another organization or individual. Generally in a loan, assets are reallocated between the lender and the borrower. So if tomorrow I woke up and felt like buying a car I could go to the bank or auto dealership and ask for a loan; $20,000 to buy a car. They might say no, but the point is I could ask. Likewise, I could wake up tomorrow and say to myself “I’d like to live in a house”, and go to the bank and ask for a mortgage loan, wherein I would borrow money to buy some property.
A loan is a form of debt instrument, or security.
A security in the world of finance is a financial instrument that is fungible, (one security can be replaced by another) negotiable and represents some sort of financial value.
The Main Culprit: Mortgages
In the event that my mortgage loan is passed, I’m now left with the task of paying back that $200 or 300k. A loan then, is when a borrower (me) receives or borrows some money (the principal) from the lender (the bank) and is required to pay back that money to the lender (the bank) at a later date.
I don’t just pay back an equal amount to the bank. For the privilege of borrowing that money I have to pay interest. The interest I pay on a loan is basically the fee I incur for “renting” the bank’s money.
The interest rates on the mortgage loan can take the form of a fixed or variable interest rate.
So I’ve made it to the bank. I know just the type of house I’d like to live in: 3 bedrooms, with a front yard and swings in the back yard. Modern, but also rustic. My loan officer informs me that I have to choose between a fixed or variable interest rate on my 25 year mortgage loan.
Look, a bank generally has two avenues from where it sources its money. One is from its clients. The other is the government. Investment banks may have other sources of capital but for simplicity’s sake let’s just use these two. When a bank gets money from the government it pays some sort of interest rate. They then turn around and charge consumers and potential home owners like me higher interest rates, making a profit of the difference.
Interest rates are always changing. In times when the economy is hurting, money is made available to banks by the government at very low rates. They do this in order to incentivize banks to make capital available to those that need it at cheap rates.
Now if this was the economic climate that day I walked into the bank looking for a mortgage loan it might make sense for me to take a fixed interest rate.
If the economy is roaring, and money is drying up then I might make a different choice. In this world, we are in the middle half to tail-end of the economic cycle. Interest rates are higher as there is less and less capital available. A 25-year mortgage loan is offered at 7.3%.
Wow. At that rate a $250,000 loan would cost me an extra $275,311 over 25 years. Were I to pick a fixed interest rate at this moment in time then I would be locked into that 7.3%. This could turn out to be a mistake. Given that we are in the middle to last part of the economic cycle I could conceivably expect interest rates to go down. If I picked a variable interest rate instead I would benefit when interest rates declined. I might pay 7.3% for the first year or two but that would steadily decline until I’m paying 5%, 4% or even 3.5%.
That makes a huge difference. Over 25 years a $250,000 loan would cost me $124, 452 in interest at 3.5%, nearly $150,000 less than at the higher interest rate.
On the other hand, if we’re making this decision at the beginning of the economic cycle and I’m presented with a 25 year mortgage rate of 2.7% then I might be inclined to take a fixed interest rate. At 2.7% over 25 years my $250,000 loan would only cost $93,490.
So really the answer to whether or not you should pick a variable or fixed interest rate is: it depends.
Back to the Future
Looking at history it would be easy to judge what you should have done. When interest rates are low and were about to shoot up, you would have picked a fixed rate and if interest rates were high you would either wait it out or pick a variable interest rate if you absolutely needed that house right that instant.
This is a simplistic explanation of a complicated topic but hopefully it shed some light. It is good to know that many academic studies have actually found that a borrower is likely to pay more interest when using a fixed rate loan versus a variable rate loan. Dr. Milevsky of York University examined mortgage interest rate data from 1950 to 2007 and found that choosing a variable interest rate loan would have saved would-be homeowners $20,000 over 15 years.
When making the decision between fixed or variable it is always important to consider the amortization period – the total length of time it will take you to pay the loan – as the longer the amortization period the greater impact changes in interest rates will have on you. A sudden change today will have ripples that permeate throughout the entirety of your contract.
To learn more, head over to Wall Street Survivor.