For the great majority of us, purchasing a home will be the largest dollar value contract we will ever transact. Also for the majority of us, it will not be a cash transaction; we will acquire a mortgage and that means we will acquire an interest payment along with the principle, the actual value of the loan for the sale price of the home minus any down payment we bring to the table.
There are several different types of loan packages available for a mortgage, but they devolve into two basic types: a fixed interest rate and a floating, or variable interest rate.
Each has advantages and disadvantages. We will concentrate on the latter, the floating interest rate, since the fixed is fairly straight forward: a locked rate for the duration of the terms of the contract. It is locked regardless of what the interest rate market does in fluctuation.
However, a floating interest rate will vary according to the market. Imagine a boat moored in a slip at a marina on the ocean shoreline. Even if the dock is fixed by piers mounted into the ground underwater, the boat is going to rise and fall with the ebb and flood of the tide.
Just so, a home mounted on a firm foundation in the ground remains stable like the dock, but the mortgage on the home is secured by an interest rate that will float like a boat on the water, rising and falling with the tide of interest rate fluctuation.
Typically, a mortgage contract will offer a finite range of fluctuation. Even if the money market varies by many points, the mortgage contract will set limits of allowed interest rate fluctuation so that it is not entirely affected by excessive fluctuation in the market.
For example, over the mortgage contract period – five, ten, or up to thirty years or more – interest rates may fluctuate plus or minus 5 points or more, but if the mortgage contract limits fluctuation to plus or minus 3 points, the mortgage interest rate cannot exceed a 3 point variation in either direction.
Referring to the boat analogy, at one time, a marina dock was entirely fixed. At extreme high and low tides, these extremes sometimes made it difficult to step onto the boat. At high tide, the boat deck was above the dock by an exceedingly high step; at low tide, it was below the dock. To ease this difficulty, marinas began to accommodate access to boats by floating the dock so that, like the boat, it would rise and fall with the tide.
This is exactly how a floating interest rate functions to ease the access to a home mortgage if a fixed rate mortgage is out of reach.
Advantages of a floating interest rate
Floating interest rates typically begin at a lower rate than fixed interest rates, making the same home more affordable to the homebuyer. The difference depends on market conditions at the time, but a lower initial rate can be expected at any time.
Some fixed interest rate mortgages come with an early pay off penalty as part of the contract. The fee calculation should be stipulated in the contract, but it is a fixed component of the contract. Typically, a floating interest rate mortgage does not incur this penalty.
If you have a distinct plan that living in the home before moving is a limited duration, such as two to five years, a floating interest rate may be a more attractive option because of the typical lower rate as noted above, coupled with the expectation that interest rates would not significantly fluctuation during that short period. It is a gamble, but one with typically agreeable consequences.
Finally, should interest rates fall during the contract period, your monthly payment requirement will fall with it. If you maintain your payment amount as a constant regardless of the reduced charge, your loan will be paid off sooner than the original contract.
Disadvantages of a floating interest rate
Since the rate floats, it can rise as easily as it may fall. If it rises, your monthly payment will increase. If you have a limited range of fluctuation in the contract, you may still be able to afford the increased payment. However, even a small increase may exceed your budget, so you need to be aware that your budget must be able to anticipate these rising fluctuations.
A floating interest rate is not the best option to choose for a full-term mortgage, typically thirty years or more.
Depending on your situation, you may find that a floating interest rate is advantageous. Caution and a confident budget can save money on a home mortgage.