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Drawbacks Of Fixed Rate Mortgage That Make Variable Loans Attractive

Conservative home owners will prefer mortgages with fixed interest rates for the stability. And those who are comfortable enough to let the market decide what they will pay for their home financing will choose variable rate loans.

Fixed rate mortgages are home loans with interest rates that are set at a specific number for a few years. It can give a home owner peace of mind in the foreseeable future. Variable rate mortgages have interest rates that vary with economic performance. When the market is booming, employment, income, and profits rise. These upward pressure on the economy takes interest rates along with it. In the same sense, when the market experiences a downturn, the opposite is true.

The key advantage of fixed rate loans comes in the certainty. And that is just about as far as it gets. Because in most places around the world, interest rates are only fixed for a certain period of time. After which, the loans become uncomfortably expensive. And depending on the risk tolerance of the borrower, going into the territory of floating interest can be nerve wrecking. This makes it almost like a protocol for households to seek options for refinancing every time a fixed rate period expires, usually between 2 to 5 years.

The thing that most people miss out on is that even though when interest rates are fixed, personal income is uncertain. Salaries can move up and down depending on economic conditions. This is especially so when your pay package has a huge variable component.

Everything will be according to plan when there is a boom, business profits rise, rental increases, incomes rise with inflation, etc. But when a recessions hits, not only can your income go down with it, but so does mortgages with variable rates. In the event that you are locked in a fixed rate home loan, you would therefore be unable to take advantage of decreasing interest rates.

A common mistake of new mortgage borrowers is getting locked fixed rates at the wrong time. As most people only take action when there is clear indication that markets are moving up, by the time action is taken, the market curve could already be primed to move the other direction. This is like a double-whammy. As you will be signing up for rates at their peak, while being locked in handicaps you from maneuvering while you watch the market tumble. This is not folklore. Historical data actually validates this.

Another big drawback of fixed mortgages concerns the penalties you have to incur when making partial redemption. The concession you must make for banks to offer you a predetermined interest is that redemptions made within the lock-in period will be subject to penalty charges. So even if you receive a sudden windfall and wishes to cut down your debt, the bank is going to take a cut. Making it sometimes impractical to redeem any portion of your loan. Depending on how much you are redeeming, you could be looking at thousands of dollar worth of penalty charges for trying to save on finance costs. Isn’t it an irony.

The bottom line I’m trying to bring across is that if you are a risk-adverse person who is looking at stability, there is a very strong argument that variable rate loans are actually better matched to your objectives. Let the market decide what you pay. Stick to adjustable mortgages and make redemptions when you have cash on hand. For more transparency, it will also be advisable to get something that is pegged to a public index.