Question

Suppose you need a 5-year mortgage loan to purchase a house that worth $450,000. The bank offers two interest rate options for you to choose:

(i). Fixed rate at 3.5%. Interest rate will remain fixed for that loan's entire term, no matter how the market interest rate changes.

(ii). Variable rate which varies with market interest rate and is typical 1.5% above the market interest rate.

Which one would you choose? Briefly explain why.

Answer 1

The choice would depend upon the expectations as to future market interest rates.

As the period is of only 5 years, one can refer to the prediction, by any economic research institution, as to the likely interest rates for the next five years.

If, as per the predicted interest rates and after adding the premium of 1.5%, the average interest rate works out to more an 3.5%, one can choose the fixed rate mortgage. Otherwise, one should go for the variable rate financing.

Another alternative is to go for the fixed rate mortgage straight away and then plan to refinance when the market interest rate moves down. For this, one has to consider the closing costs.

Another option is to go for the variable rate mortgage and then hedge through interest rate futures to pet the net interest to a fixed rate.