0
$\begingroup$

Conventional wisdom is to lock in a low rate (by getting a fixed-rate mortgage instead of ARM) while we're in a period of historically low interest rates.

Assuming that you are going to own a house for the full 30 year mortgage term and you have the ability to repay or refinance your loan without penalty, is a fixed-rate mortgage strictly better than a variable-rate mortgage? Or is the opposite true: Do you get a risk premium for taking on the risk of changing rates?

By better, I mean is the present value higher? Or, if it depends on your personal discount rate: how low would your discount rate need to be to make using an ARM a higher-NPV choice than a FRM?

$\endgroup$
1
  • $\begingroup$ Again I sincerely ask you to add a clear example with the exact number of the current fixed mortgage rate and the current variable mortgage rate. $\endgroup$
    – High GPA
    Mar 6, 2022 at 14:23

3 Answers 3

1
$\begingroup$

The fixed and variable interest rate loans compete against each other. As a consequence the expected cost of them should be more or less equal otherwise why would ever someone take variable interest rate loan?

As explained by High GPA in her +1 answer/comment, the fixed interest rate loans will have much higher interest rate than the variable interest loans. This is because with fixed interest rate you are not just purchasing a loan you are also purchasing an interest rate risk insurance. Bank will charge you for that extra insurance, it won't give it to you as a free gift.

When it comes to flexible interest rate you are purchasing just the loan without any extra insurance so the interest rate will be lower but you bear a risk.

So neither can be strictly better option for consumer. If you are happy with bearing risk then you taking the risk would be better option. If you are risk averse then you should get yourself that extra insurance fixed interest rate provides despite the high cost. It is similar to extra travel insurance for baggage. There is always some chance baggage will get destroyed so you can't simply claim that not paying extra buck for that travel insurance is good idea a priori.

$\endgroup$
1
$\begingroup$

What do you mean by "better"? Do you mean risk, by any chance? Thinking in terms of risk this could mean changes or fluctuations in present value of debt for instance. Then a floating rate mortgage is better as for fixed rates the PV of your debt changes considerably. However, I think most people think in terms of consumption risk, then the case is not entirely clear. John Y. Campbell wrote an article about exactly this question: Household Finance. Hope this helps

$\endgroup$
1
  • $\begingroup$ I mean better risk-adjusted return. Thank you for the article. $\endgroup$
    – Zaz
    Mar 4, 2022 at 3:57
1
$\begingroup$

This is a long comment rather than a full answer.

I think the OP should clarify the meaning of "lock" by creating an example. Usually, by "locking" a rate, you are slightly increasing your current rate. This is an example from my side:

Current central bank base rate: 0.5%

Current variable mortgage rate: 2.5%

Current fixed mortgage rate: 3.5%

Usually, by "fixing" the rate, you cannot fix your rate at 2.5%. You can only fix it at 3.5 percent. So if you fixed the rate and the rate will heavily raise in the future, you are better off. If you fixed the rate and the rate stays low, then you will lost your money.

However, if the OP means fixing the rate at 2.5%, then it will be another story.


The reason why I ask OP to add a specific example is that the answer to the question is heavily depend on numbers.

I am assuming that OP or OP's friend is deciding about locking the rate. So the answer is heavily depend on the exact rate OP got from the bank and the country. If you got a fantastic fixed rate and I give OP a suggestion of not locking the rate, then I am making a mistake. So I think the updated question is still lacking critical information.

Nevertheless, from the new update we know that the OP is asking about a real-life scenario rather than an ideal model. So I will use the real-life number from Canada to answer the question.

You can find the historical variable rate here: https://www.ratehub.ca/5-year-variable-mortgage-rate-history

And you can find the historical fixed rate here: https://www.ratehub.ca/5-year-fixed-mortgage-rate-history

It is very clear that in the past ten years, the variable rate is always fluctuating below 3%, and the fixed rate is always above fluctuating above 4.5%.

So "locking the rate" is only slightly profitable if you think that the variable rate will rocket from around 1% (current rate) to >4.5%. I think the event is highly unlikely.

Well, it is possible that you have insider information that the variable rate will go up to 4.5% soon. If this is the case, I suggest you to buy interest rate future option product rather than "lock your rate", because the former action will be way more profitable.

Usually, buying a fixed rate mortgage product is buying both a mortgage product AND an insurance. As you know, any insurance provider is for profit -- they want to make money from you.

This is why the salesmen at banks are pushing people to get the rate fixed. Of course, I won't say "locking the rate" is a conventional wisdom. The salesmen are trying to make people accept this belief such that the salesmen can make their money.

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service and acknowledge you have read our privacy policy.

Not the answer you're looking for? Browse other questions tagged or ask your own question.