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If you’re on the hunt for a new home, one of the first decisions you’ll face is deciding if you want a fixed- or variable-rate mortgage. While one boasts security and peace of mind, the other offers unparalleled flexibility that gives you more control over your interest rate. As a first-time home buyer especially, you’ll likely encounter a lot of terms and processes you may not understand as you move through the experience of shopping for and buying a home. Understanding each of these mortgage rate options is a great place to start your education and will help you make the best decision for your current needs when the time comes to make a choice.
What’s A Fixed-Rate Mortgage?
With a fixed-rate mortgage, the rate you get when you sign stays the same throughout your term. The downside with this is that the bank is taking a chance lending you money over a long period of time at a fixed rate, so they need to factor the risk and opportunity cost into the rate they offer you. To compensate for rates potentially going up during your term, they’ll charge you a slightly higher fixed interest rate to account for it. This option lets you move forward worry free. You can sleep peacefully at night knowing your rate is locked in.
It’s important to note that choosing a fixed rate mortgage is definitely still a risk as you’re betting that you won’t need to sell or refinance during your term. Most banks’ penalties on fixed-rate mortgages are astronomical, so take that into consideration when you make your choice. It’s more common than you think for people to break their mortgage term.
Benefits Of Fixed-Rate Mortgages
There are plenty of benefits to choosing a fixed-rate mortgage:
– They tend to be easier to understand
– They make it easier to create a budget as the cost is fixed every month
– You’ll have a sense of security as you’ll know what to expect over your term
– The interest charge is reduced as you pay down the principal
What’s A Variable-Rate Mortgage?
With a variable-rate mortgage, the bank assesses their overnight rate eight times each year and as a result, their prime rates change. Having a variable rate mortgage means that each time the bank does this, there’s a chance your interest rate will change over the course of your mortgage term (typically 3 – 5 years).
The benefit is that you’ll likely save right from the start with a lower interest rate and you’ll have the luxury of choice with far fewer penalties for breaking your mortgage agreement. If you can live with some uncertainty, you desire the flexibility and are focused on saving more money up front, a variable-rate mortgage may be the best option for you.
Benefits Of Variable-Rate Mortgages
There are plenty of benefits to choosing a variable-rate mortgage:
– Your interest rate will likely be lower than with a fixed-rate mortgage
– They tend to be less expensive over the term of the mortgage
– If you’re looking to secure a larger loan, an initial lower payment may help
Open Vs. Closed Fixed Mortgages
When you choose a fixed mortgage, you’re able to make a decision to keep it open or closed. While it may seem like a simple choice, it can impact a lot throughout the course of your term. An open fixed mortgage is most common and is best suited for you if:
– You intend to sell your home and pay off the mortgage with your proceeds, as choosing a closed mortgage will have you facing some significant prepayment penalties.
– You’re expecting an inheritance or your income is about to increase, as you can increase your monthly mortgage payments or pay a chunk off in cash without facing any penalties or fines
You may consider a closed fixed mortgage if you’re wanting to secure a lower mortgage rate and you aren’t planning to increase your monthly payments or pursue refinancing at a later date. Closed mortgages offer a lot less flexibility when it comes to changing payments or making extra payments when you have the opportunity, so be sure you do your homework to figure out if a closed mortgage is worth the lower interest rate.
Open Vs. Closed Variable Mortgages
When it comes to variable rates, closed mortgages tend to have lower prepayment penalties than closed fixed mortgages. In some cases, it may be wise to choose a closed variable mortgage to get access to the lowest mortgage rates, while also somewhat limiting the potential size of your prepayment penalty, in case you need/want to pay off your mortgage or refinance. The main drawback of variable mortgages is that you’re always vulnerable and exposed to changes in the prime rate, which could increase your regular monthly payments throughout your mortgage term.
Variable-Rate Mortgages: Lock In Option
With a variable rate mortgage, you have the option to lock in to a fixed rate at any given time during your term. While this sounds like a good compromise should rates start increasing along with your monthly payments and general stress level, it isn’t as easy to lock in as it may seem.
Bond yields, which largely determine fixed mortgage pricing, typically rise well before the Bank of Canada is ready to hike rates. As a result of this, fixed rates increase prior to prime rate, and most often do so without notice. For an average person, the chance of knowing exactly when to make the jump from variable to fixed is slim to nil. If you find your lender is giving you a hard time and you aren’t able to make the smooth transition into a fixed rate as anticipated, it may be wise to compare the cost of leaving by calculating the penalties/fees you’ll encounter if you choose to find another lender.
Understanding Mortgage Penalties
There are penalties for breaking both fixed- and variable-rate mortgages, but typically the variable rate penalties are much lower. Canada’s National Housing Act mandates that for variable-rate mortgages, the penalty is always equivalent to three months’ interest. For example, imagine you have a $200,000 variable mortgage at 3.8%, amortized over 25 years. On this particular mortgage, let’s say your monthly payment is $1,030, and the interest portion is $627. Multiply that by three and you get $1,881. That’s your penalty.
A fixed-rate mortgage has a much higher penalty and is often difficult to calculate. In a broad sense, it’s based on your interest rate differential (IRD), which is the difference between the rate of your current mortgage and the rate the lender can now get for their money. It’s advised to seek assistance from a mortgage broker so you can ensure your calculation is as accurate as possible. We can estimate that a typical penalty for breaking a $200,000, 5-year fixed-rate mortgage locked in at 5.9% after 2 years, given a 3% prime rate, would be roughly $12,000. When there’s that much money on the line, it’s very important that you know your exact projected penalty before you make any decisions.
Fixed- Vs. Variable-Rate Mortgage: What’s Right For Me?
If you’re on a pretty tight budget and have a hard time dealing with unexpected expenses, a fixed-rate mortgage may be the best choice for you to ensure you and your family don’t need to endure any financial hardship throughout your term.
Choosing a variable-rate mortgage means more flexibility, but it also less security as you’re essentially at the mercy of the prime rate throughout your term. You could end up saving a significant amount of money over time, but you take the chance that the rates may go up, which in turn could increase your monthly payments significantly. If your expendable income can fluctuate and you’re not worried about sticking to a specific payment every month, you may prefer taking the risk on a variable rate mortgage.
Keep in mind that in Canada, it’s quite common to choose a mortgage term that lasts a few months to 5 years so you can change your mind at the end of your term and make a switch to a better suited option if your original choice didn’t pan out as expected.
When it comes to mortgages, you have lots of options, but understanding the difference between each one and how it will impact you in the short and long term is a very important part of the process. Looking for some guidance and industry insight? Reach out to our team to learn more about your mortgage options and how to make the best selection for your goals and needs.