By Tom Bradley

Last week a friend asked me what his daughter should do with her mortgage. The bank was giving her the option of going with a variable rate mortgage at 2.85% or a 5-year fixed at 3.5%.

Investment professionals get asked this question all the time by friends and family. I’ve come to learn that the askers have way more interest in this topic than anything I could ever tell them about our funds or their portfolio. This is ‘food on the table’ stuff.

So how did this investment professional answer the question?

With regard to the lower variable rate, there is no free lunch here. Research reveals that going variable saves money over the long run (Note: 30 years of declining rates has a huge influence on the numbers), but it comes with the risk that monthly payments will go through the roof if rates rise significantly. A borrower should only go the variable route if she/he has the resources and stomach to absorb a big increase for an extended period of time.

As for the fixed rate mortgage, we have to keep in mind that 3.5% for 5 years is an UNBELIEVABLE rate. Yikes! Knowing you’re going to have low monthly interest payments until 2015 sounds pretty good. We shouldn’t forget that we’re living in an artificially low rate environment right now. It won’t always be like this.

As an investor, I’m always comparing reward versus risk. There is a good chance that a variable rate mortgage will win over the next 5 years, but the potential risk is substantial. It seems to me the borrower has a chance of winning small or losing big. Go fixed.

(Note: With regard to the numbers, I’m simplifying grossly here. Rates and conditions are different in each situation. And I’m told that variable mortgages are available at lower rates.)