LOUISE FAIRSAVE: Mortgage rates
THIS ARTICLE discusses the scenario for consideration in this series of presentations on using debt wisely: Is the statement, “The best mortgage to hold is a fixed rate mortgage” true or false?
This is a sure “it depends” answer. The advantage of a fixed rate mortgage is that the borrower will know exactly how much to pay each month even if the lender’s base loan interest rate changes. That is because a fixed rate mortgage is one where the loan interest rate is fixed for the agreed term of the loan.
If the entire mortgage period is on an agreed fixed rate, the borrower will pay the same monthly amount for the entire term of the mortgage. Each payment instalment is applied first to the interest due on the loan and the balance to reduce the principal amount owed. In the beginning stages of the mortgage, most of the payment instalment is applied against the interest. Then as the principal balance reduces gradually over time, more of each payment instalment is applied to the principal loan balance so that the mortgage is fully repaid by the final payment instalment.
Typically though, lenders are hesitant to commit to a fixed rate mortgage period for the long term. They try to avoid the risk of the interest rate rising well above the agreed fixed rate level resulting in reduced profitability for their business.
Interest rate movements respond to the prevailing economy. When there is economic growth and inflation, interest rates tend to rise. On the other hand, when there is a downturn in the economy, interest rates tend to fall. Most lenders are willing to project expected trends in interest rate movements over the forthcoming two, three or five years. However, lenders are less confident of interest rate movements predictions say over ten years or more.
So, in negotiating a mortgage, it may be possible to secure agreement on a fixed rate period of two, three or five years. After that period had expired, the mortgage interest will typically move to a variable rate basis.
A variable rate mortgage will normally set the interest rate level at a number of percentage points above the lender’s base rate or the prime rate. In this way, there is relative transparency as the movement in the interest rate will follow the base rate by the agreed number of percentage points.
The major disadvantage of the variable rate mortgage is that if the interest rate shoots up in response to positive trends in the economy, the borrower could find the mortgage instalment payment rising to a stressful level. A $1 500 monthly mortgage payment may rise to say $1 900, upsetting a carefully planned budget for spending.
First-time buyers, persons on tight budgets and young couples who may just be starting to exercise their spending budget muscle would normally welcome an initial fixed rate mortgage period of three to five years. Yet, appreciate that the fixed rate tends to be higher that the prevailing base rate. After all, the lender is taking on the risk of the interest rate moving unfavourably during the period. The borrower may have to pay extra for the lender undertaking that risk.
Then, note that if there is favourable movement in the interest rate for the lender (usually a drop in the prevailing interest rate) during the fixed rate mortgage period, the borrower does not benefit. Thus, it all depends on the comfort and peace of mind that the borrower would like to have about the mortgage payment.
A mortgage commitment tends to be the sole major long-term financial commitment for many people. A better understanding of the terms used by lenders, and an appreciation of the pros and cons of varied offers will assist in making that very important debt decision.
• Louise Fairsave is a personal financial management adviser, providing practical advice on money and estate matters. Her advice is general in nature; readers should seek advice about their specific circumstances. Email: [email protected]
This column is sponsored by the Barbados Workers’ Union Co-op Credit Union Ltd.