Home Equity Interest Rates: Go Fixed or Variable?

In determining whether to go variable or fixed when choosing a home equity interest rate, the most important consideration is the breakeven time period. In most cases, a variable rate loan will offer a more attractive interest rate than a fixed rate loan. Depending on how frequently the rate resets, the maximum adjustment permitted by the loan, and your expected payoff timeframe, a variable or a fixed rate home equity loan or mortgage may be more attractive.

Calculating the Breakeven Period

If you want to maximize the attractiveness of a home equity loan or mortgage by deciding between a variable rate loan and a fixed rate loan, you must determine at what point in time you will hit the breakeven level. For example, if a lender is offering a fixed rate of 6 percent and a variable rate of 4 percent, it is difficult to determine which loan is more attractive. The additional information you need to have includes the facts that the loan may adjust by no more than 1 percent per year, and that the loan has a six percent maximum upward adjustment. You can now determine that the breakeven period is 5 years from when the loan is opened if the variable rate loan were to adjust up by the maximum amount each year. Essentially, if the loan were to use the maximum reset amount, you would pay 4 percent, then 5, then a year at 6, then 7, then 8. While the calculations are general, a precise compounding calculation is not going to benefit you significantly.

The calculation can be done simply by looking at the reset amount and the frequency with which this can occur. If you want to bet on interest rates, and do not believe that rates will increase significantly in the near-term, then this period may be extended, but the most conservative and safe way to estimate this time period is to assume that the loan will reset higher at the maximum rate in the shortest amount of time possible. This will prevent unexpected surprises and if, as you may believe, interest rates do not rise or do not rise quickly, the extra savings is a bonus.

Acting on the Information

What you should take away from this is that if you plan to move or pay the loan off within 5 years (following on the above example), the variable rate is a better option. If, however, you plan to service the debt for the life of the loan, the fixed rate may be more attractive. The other major consideration is to determine whether you will be able to afford the higher monthly debt service level as the loan resets higher. It may be that you think you will move within 5 years, but as soon as the loan resets above the 6 percent level, you will not be able to afford the monthly payment; if the excess funds are saved along the way, they could then be used to make the higher payments, but this requires discipline. If it is unlikely that you will save the differential in the early years then, while the variable rate is more attractive, the forced discipline of the fixed rate will be more workable for your individual needs.


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