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Explainer: Choosing a fixed- or variable-rate loan

I recently decided to sell my house. My kids are grown, and it was far more house than I need. I was having trouble keeping up with the yard work, and I'm looking to downsize. I expected my house would sit on the market for quite awhile given the state of mortgage markets, but amazingly it sold the day it listed. There was a very short escrow period.

Unfortunately, I had not yet found a new place to live. I thought I'd have plenty of time and had hardly even started looking, so I quickly rented on apartment on a month-to-month basis. That will allow me to take my time and find something smaller and easier to care for, and something I really like.

Once I find the right house, I'll need to qualify for a mortgage loan (though I may pre-qualify so I know my limits beforehand). One of the decisions I'll face is whether to take out a fixed- or variable-rate loan. What will go into this decision? Two things mainly: my forecast of what will happen to interest rates relative to market expectations, and how much interest rate risk I'm willing to tolerate.

When a fixed mortgage rate is set, there's an assumption about what will happen to interest rates over the life of the loan. The more interest rates are expected to increase during that term, the higher the fixed rate of interest that lenders will charge.

If a borrower believes interest rates will be higher than the market's assessment -- higher than is assumed in the fixed rate -- then a fixed-rate mortgage is better than a variable. But if the borrower has reason to believe interest rates will increase slower than the assumption built into the fixed rate, then the variable rate is the better deal.

How can you determine the assumed rate of increase? The main thing that changes interest rates is the expected rate of inflation, so assessing the expected rate of inflation (e.g. see here or here) over the life of the loan is a good way to determine the assumed trajectory of interest rates. Currently expected long-run inflation is just under 2 percent. So. if you believe inflation will increase faster than 2 percent, a fixed rate is best.

But even if you believe the opposite, i.e. that inflation will be lower than the market believes, you may still want to avoid a variable-rate loan. You could be wrong, and inflation could be much, much higher than you expect, even higher than the market expects. In that case, your monthly payments could increase quite a bit -- enough to perhaps make your budget unbearably tight.

Thus, an important consideration in the fixed versus variable decision is tolerance for risk. Risk lovers will lean toward variable rates, while risk avoiders -- like me -- will lean toward fixed rates. The less tolerant you are of risk, the more certain you would need to be about your inflation forecast before taking a variable-rate loan.

I suspect that most people don't have a strongly held opinion about whether inflation will, on average, be higher or lower over the life of the loan than the market's assessment (and for those who do, most probably expect inflation to be higher than 2 percent, rather than lower). If so, then interest rate risk is the dominant factor, and those who value certainty should take the fixed-rate option.

Finally, I should add that the choice of mortgage isn't as clear-cut as fixed versus variable. Also available are hybrid loans, for example, a loan with a fixed rate for the first five years and then a variable rate thereafter. That brings up other considerations, e.g., if you're absolutely certain you'll sell your house and move within five years, a five-year hybrid option would be better than a traditional fixed-rate mortgage. However, once again, the risk that you may get stuck there beyond the planned five years should also be part of the decision.

My choice will be a fixed rate. I believe that long-run inflationary expectations are correct -- that the Fed will keep inflation at or near its 2 percent target. And I'm very risk-averse. So, I prefer the certainty a fixed rate offers.

That brings up the last point. The certainty that a fixed rate brings is not free: An "insurance fee" is priced into the difference between a fixed and a variable rate, but that fee is low enough to make the fixed-rate loan attractive to me. Your taste may differ.

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