Variable rate vs. Fixed rate mortgages: which is better?

Today we will talk about mortgages, trying to answer a question some friends asked me: “Are better fixed rate mortgages or variable rate mortgages?“. In short, the most appropriate answer is “it depends“.
There are some factors (among many others…) that you should keep in mind when choosing between a variable rate and a fixed rate mortgage:

• Expectation on interest rate trend: if you’re convinced that interest rates will diminish or will stay steady, you should prefer variable rates; instead if you’re convinced rates will rise, you should choose a fixed rate mortgage.
• Risk adversion: as a general rule, the more one is risk-adverse, the more one should stay away from conditions that provide variability. To choose a variable rate mortgage is a risk since interest rate may rise, with the obvious consequences on payments: if you don’t like risk, stay away from variable rates.
• Affordability: in case rates rise and monthly payments increase, would you still be able to repay them? If you think that an interests increase might hamper your payments, you should prefer a fixed rate mortgage.

Said this, let’s make a step further, and look inside payments: in fact, they are composed of two part:

• The principal (the sum of money owed as a debt, upon which interest is calculated);
• The interests (the “fee” paid for borrowing  the principal).

In an mortgage amortization schedule, payments are usually constant, that means that the sum of principal and interest is fixed, but it does not mean that principal and interest portion is steady. All the contrary: at the beginning, the interest portion has a major role in the payment, but this role decreases in time, and near the end payments consists mainly of principal repayment.

How principal (red) and interest (blue) ratio changes in time during a mortgage (data used: 25-years amortization schedule, yearly payments, 4% constant interest rate)

If you take this in account, you’ll understand that it’s important what will do interest rates mostly in the first part of the mortgage, while we can be less worried about what will happen do at the end of the mortgage, since an increase (or a decrease) in interest rates won’t affect too much payments (since they will be composed mostly by the principal).
Moreover, this also explains why banks allow you to choose a fixed rate reimbursement plans: that’s because they don’t need to foresee interest trend for the whole mortgage duration, and with a little increase at the interest rate (in comparison to the variable rate) they can recover possible losses due to interest rate changes.


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