If you have been thinking about buying or building a house using a home loan, you must know that when you take out a mortgage, you agree to pay back the entire amount you borrowed plus interest. The amount of interest you will pay over the loan's tenure will depend on the type of mortgage rate you get.
There are two types of mortgages based on the type of interest: fixed and adjustable rates. The type of interest rate you choose will significantly affect the cost of your loan. This is why you must take time to understand the difference between the two.
Both fixed and adjustable-rate mortgages have pros and cons; the type you choose will depend on different factors, including your financial situation, loan tenure, and risk tolerance.
A fixed-rate mortgage is a type of home loan where your interest rate is locked and won't change over the tenure of your loan. The interest rate you agree to when you take the loan will remain unchanged during the mortgage term regardless of whether market rates go up or down.
The rate you receive when you apply for a mortgage will typically be the prevailing market rate or current central bank rate (CBR). However, the lender will offer you a different rate depending on the terms that you agree on. For instance, the rate can be lower when you take a shorter mortgage term or if you pay more upfront as a down payment.
Once you take the loan, you will be required to make a monthly repayment. A portion of the repayment will cover interest, and a portion will go toward the principal. The fixed-rate mortgage uses a reducing balance method to calculate interest. This means that most of your repayment will go towards paying off the interest during the early years. As the loan matures and approaches term, this will change, and more payments will go towards the principal.
Lenders might use different amortisation methods depending on how fast they want you to repay the interest. If your lender allows extra payments, any extra money you pay with your monthly installments will likely go toward the principal.
The biggest benefit of a fixed-rate mortgage is its predictability. The borrower will know how much interest they will pay by the end of the loan tenure. This allows them to plan, ensure they can afford the loan, and negotiate terms that suit their needs.
When you take a fixed-rate mortgage, only the interest is locked in when you close on the home loan. Other charges, such as insurance and taxes, can fluctuate over the term of your loan. Additionally, when you miss or delay a payment, you will likely be fined, which can increase how much you pay in some months.
Fixed Rate Mortgage suit you if:
An Adjustable Rate Mortgages is a variable interest rate that changes throughout the mortgage. It is the opposite of a fixed-rate mortgage, where the interest rate remains unchanged throughout the life of the debt.
Your interest rate will either go up or down depending on the economy and market conditions. Adjustable Rate Mortgages interest rate moves with the market rates or the lender's benchmark rate. The rate can be tied to the central bank rate or other indexes.
Adjustable Rate Mortgages are typically attractive when interest rates are low. When you take this type of mortgage, you should be ready to bear a higher interest rate risk — the risk of rates rising in the future.
The primary advantage of an adjustable-rate mortgage is that you can pay less in interest whenever rates go down. Conversely, a rise in interest rate can increase the loan cost. While chasing the former, you must be prepared for the latter.
Mortgages with adjustable interest rates typically start with a fixed rate for the first 5 to 7 years or depending on your lender. During this time, a lender usually offers you the prevailing rate depending on their benchmark. At the end of that period, the rate will be revised to match new market rates. At this juncture, interest will go up or down, and subsequently, your monthly repayment will change.
While interest rate benchmarks are revised multiple times a year, the adjustable rate of a mortgage isn’t. For instance, the CBR is revised every two months by the central bank of Kenya. But when it comes to the mortgage rate, you can negotiate with your lender about how often the rates are adjusted. This can be once, twice, or thrice per year, depending on what you agree with your lender.
Adjustable Rate Mortgages can suit you if:
When it comes to taking out a home loan, it's crucial to understand all the details of the loan products you are considering. You don't want to find yourself in a situation where you're paying more than you need to or can afford.
Remember that your financial situation might dictate the type of interest rate your lender offers, and other factors can go into deciding the type of interest rate you receive. So, do your research and solicit the advice of mortgage experts to ensure you're taking a home loan that best suits your financial situation.