Choosing between a fixed or variable mortgage is a very important decision you’ll need to make when buying a home. Each option has its benefits and drawbacks, and understanding these can help you make an informed choice that aligns with your financial situation and goals. In this guide, we’ll explore the key differences between fixed and variable mortgages, how they react to interest rate changes, and what you should consider before making your decision.
Fixed or Variable Mortgage – Understanding the Difference
Fixed-Rate Mortgages
A fixed-rate mortgage offers a stable interest rate for the entire term of the loan, usually between 1 and 5 years in Canada. This stability means your monthly payments remain the same, regardless of changes in the market interest rates. This can provide peace of mind, especially in a volatile economic environment.
However, if market rates drop significantly, you won’t benefit from the decrease until your term ends, and you renew your mortgage.
Variable-Rate Mortgages
Variable-rate mortgages, on the other hand, have interest rates that can fluctuate based on the prime rate set by the Bank of Canada. When the prime rate changes, your mortgage rate can go up or down. There are two types of variable rate mortgages, an ARM (Adjustable Rate Mortgage) where the payments go up and down with the changes in the market, and a true variable rate mortgage where the payments stay the same and the amortization adjusts up or down with the rate changes. It is important to talk with a broker about the pros and cons of each to decide what is the best product for you.
Historically, variable rates have outperformed fixed rates, offering savings over the long term. Furthermore, variable mortgages often come with a three-month interest penalty for breaking the mortgage, which is generally lower than the penalty for fixed-rate mortgages.
How Interest Rate Changes Affect Mortgages
Impact on Payments
As mentioned before, some will adjust your monthly mortgage payments directly, while others might change the amortization period—the total time over which you repay the loan. Most commonly, however, your payments will change with the interest rate, and your lender will notify you of any adjustments.
For those who want the benefits of a variable mortgage but prefer consistent payments, it’s possible to arrange this with your lender. This approach involves adjusting the portion of your payment that goes towards the principal versus interest, keeping the total payment amount the same.
Breaking the Fixed or Variable Mortgage
Life is unpredictable, and many Canadians break their mortgage contracts before the end of the term. Approximately 60% of Canadians break their mortgages around the three-year mark of a five-year term. Variable-rate mortgages are often more flexible and come with lower penalties for breaking the contract. If there’s a chance you might need to break your mortgage early, a variable-rate mortgage could be the more cost-effective option.
Historical Performance and Flexibility
Historically, variable-rate mortgages have performed better than fixed-rate mortgages, providing lower interest costs over time. Another advantage of variable-rate mortgages is the ability to switch to a fixed rate during your term without incurring penalties. This flexibility can be invaluable if interest rates start to rise, and you want to lock in a stable rate.
Fixed-Rate Mortgage Considerations
Many borrowers fear the possibility of rising rates with a variable mortgage. The prime interest rate, set by the Bank of Canada, influences the rates charged by lenders. While significant jumps in rates are rare, even small increases can affect your payments.
For example, if you have a $100,000 mortgage at a 3% variable rate, a 0.25% increase in the prime rate would raise your monthly payments from $473 to $486. This incremental increase can be easier to manage than the potential shock of a large rate hike at the end of a fixed-term mortgage.
More Than Just the Rate: Other Key Factors
Prepayment Privileges
Beyond the interest rate, consider the mortgage’s prepayment privileges. These allow you to pay off more of your mortgage without penalties, which can help reduce the overall interest you pay.
Convertible To A Fixed Rate
Almost all lenders will allow you to switch your variable rate mortgage into a fixed rate at any point during your term, without penalty. They will offer the respective fixed rate mortgage to match the remaining term of your mortgage.
Penalty Calculations
Fixed-rate mortgages usually come with higher penalties for breaking the mortgage early, often calculated using the interest rate differential (IRD). In contrast, variable-rate mortgages typically have lower penalties, usually calculated as three months’ interest.
Choosing the Right Product
It’s crucial to choose a mortgage product that fits your lifestyle and financial situation. For instance, if you’re in a job that might require you to move frequently, a variable-rate mortgage might be better due to its lower penalties for early termination.
Conclusion
Deciding between a fixed or variable mortgage requires careful consideration of your financial situation, future plans, and comfort with potential interest rate fluctuations. Both types of mortgages have their advantages, and the right choice depends on your individual needs and circumstances.
For personalized advice and to explore your options, reach out to Alex Lavender, your trusted mortgage broker. With expert guidance, you can make an informed decision and secure the best mortgage for your unique situation