When a bank lets you take out a mortgage to buy your house, you will be expected to pay back interest throughout the tenor of the mortgage. The bank will let you choose one of two ways to pay back this interest: Fixed rates or floating rates. What’s the difference?
A floating rate is an interest rate that will continuously change throughout the tenor of the mortgage. Now this rate doesn’t change randomly; the rate is tied to a published statistic. Many times a floating rate will change in accordance with the Consumer Price Index (CPI), a bank’s “prime rate”, or the interest rate a United States Treasury bond yields. Those control what your floating rate will be. If your floating rate is tied to the Treasury bond interest rates, the moment Treasury bonds increase their interest rates, your mortgage interest rate will also increase. You could end up paying much more on your mortgage than you expected.
Sounds a bit risky, doesn’t it? Why would people agree to an interest rate that could drastically rise ten years from now? Perhaps they believe the floating rate will actually decrease over time. Perhaps they were enticed by the teaser rate. The teaser rate is a very low rate that a floating interest rate will initially have. For example, the bank can offer you a mortgage with a floating interest rate. The interest will be very low for a number of months or years, but then will rise by a significant amount. This initial low interest rate will always be less than the fixed rate they offer, but will eventually be far more.
What’s one more reason someone might opt for a floating rate on a house mortgage? They plan on selling their house soon. Someone will buy a house with a mortgage that they are paying a very lower teaser interest rate on initially. They know that that interest rate will increase in, let’s say, three years. They will try to sell the house before those three years are up. Simple right? Just pay a very small interest rate to the bank for three years, then ditch the house before you have to start paying a large interest rate. The recession of 2008 made very clear that this strategy has a risk to it. In 2008, the housing market fell. The economy was on the brink of collapsing, and people stopped buying houses. People who thought that they would be able to sell their house before their interest rate skyrocketed were not able to sell it. They were stuck with it and had to pay a very large interest rate that they were not prepared to pay.
Fixed rates are fairly straight forward. For the entire tenor of the mortgage, you will always pay the bank the same interest rate. This is a much safer option, because you know what rate you will paying ten months from now or even ten years from now.
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