Question

Suppose you need a 5-year mortgage loan to purchase a house that worth $450,000. The bank offers two interest rate options for you to choose:

(i). Fixed rate at 3.5%. Interest rate will remain fixed for that loan's entire term, no matter how the market interest rate changes.

(ii). Variable rate which varies with market interest rate and is typical 1.5% above the market interest rate.

Which one would you choose? Briefly explain why.

Answer 1

Fixed interest rate loans are loans in which the interest rate charged on the loan will remain fixed for that loan's entire term, no matter what market interest rates do. This will result in your payments being the same over the entire term. Whether a fixed-rate loan is better for you will depend on the interest rate environment when the loan is taken out and on the duration of the loan.

A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest rates change. As a result, your payments will vary as well (as long as your payments are blended with principal and interest).

Generally speaking, if interest rates are relatively low, but are about to increase, then it will be better to lock in your loan at that fixed rate. Depending on the terms of your agreement, your interest rate on the new loan will stay the same, even if interest rates climb to higher levels. On the other hand, if interest rates are on the decline, then it would be better to have a variable rate loan. As interest rates fall, so will the interest rate on your loan.