When shopping for a mortgage, one of the big decisions you’ll need to make is whether to go with a fixed or variable rate. The truth is, each one has its advantages and its drawbacks. Deciding which type of mortgage is best for you starts with understanding how fixed and variable rates work, the ways in which they are similar and how they are different.
What’s A Fixed-Rate Mortgage?
With a fixed-rate mortgage, the interest rate doesn’t change for the duration of the mortgage term. In Canada, 5-year fixed-rate terms have traditionally been the most popular choice for borrowers, although most lenders offer terms ranging anywhere from 1 – 10 years in length.
The primary advantage of a fixed-rate mortgage is the security of knowing that your rate will stay the same during the mortgage term, regardless of what happens in the economy. The borrower knows exactly what their mortgage costs will be, including the time it’ll take to pay off their mortgage in full.
If there’s a downside to a fixed-rate mortgage, it’s that the borrower can’t benefit if and when rates decrease. There’s always a chance that you could lock in your rate and then see rates drop significantly over the course of your mortgage term. Unless you go with an open mortgage, you’d be subject to a penalty if you tried to get out of a fixed-rate mortgage. In other words, it doesn’t usually make sense to break a fixed-rate before the end of the term.
What’s A Variable Rate Mortgage?
A variable rate mortgage, sometimes referred to as an adjustable rate mortgage (ARM), fluctuates with the bank’s prime lending rate, which is tied to the Bank of Canada prime rate. As the prime rate moves up or down, the interest rate of a variable mortgage changes along with it. For example, if your lender’s prime rate is 3.60%, and your variable rate mortgage is priced at bank prime – 0.75%, your mortgage rate would be 2.85%. If the bank raised its prime rate by 0.25%, in accordance with the Bank of Canada, your mortgage rate would increase to 3.10%.
Because variable mortgage rates can fluctuate, they’re considered to be riskier than a fixed-rate. But that risk also comes with a potential reward. That is, when rates drop, the holder of a variable rate mortgage saves interest and more of their monthly mortgage payment is applied to the principal balance. The result can be thousands of dollars in savings over time, with the borrower paying off their mortgage sooner. On the flip side, if interest rates were to rise sharply, the variable rate mortgage holders would see their interest costs go up, which could lead to an increase in their monthly payment.
Open Vs. Closed Mortgages
A fixed mortgage can be either open or closed. The same goes for a variable rate mortgage. A closed mortgage is one where the borrower is committing to a specific mortgage term or time period. This could be anywhere from 6 months to 10 years. In a closed mortgage, if a borrower breaks the terms of the mortgage during this term, they’ll be subject to a prepayment penalty or early termination fee.
With an open mortgage, the idea is that the borrower is able to pay off the mortgage at any time, in full or in part, without a penalty. They may still be subject to other administrative costs, such as a mortgage discharge fee. Open mortgage rates are higher than closed. Usually, the only reason someone would opt for an open mortgage is that they feel there’s a good chance they’ll need to break the mortgage prior to the end of the term and they want to avoid being charged a penalty. This could occur if they sold their home, decided to transfer their mortgage to a different lender or received a large sum of money they wished to use to pay off the mortgage.
Open Vs. Closed Variable Mortgages
Borrowers usually have the option of choosing an open or closed variable mortgage, with the latter being the more sensible option in most cases. Open mortgages allow the borrower to pay off the mortgage in full at any time without a penalty, but the interest rate on an open mortgage is much higher than closed. Because of this, open mortgages only make sense if you’re planning to sell your home in the near future or pay off the mortgage in full for any other reason.
With a closed variable rate mortgage – while the interest rate can change – you’re still subject to the conditions of the term you’ve chosen, say 5 years. If you pay off the mortgage early, you’ll be subject to a prepayment penalty.
Variable Rate Mortgages: Lock In Option
You may be wondering if you can switch between a fixed and a variable rate in the middle of your mortgage term. While you can’t move from a fixed to a variable without incurring a penalty, you can usually switch from a variable to a fixed with a couple of conditions.
Let’s say you are 2 years into a 5-year term on a closed variable mortgage. You could switch to a fixed rate, providing that the term you choose is at least 3 years in length, to account for the 3 years remaining in your original term. Your new fixed-rate would be based on what’s available when you make the switch.
The ability to convert to a fixed-rate can be reassuring to variable rate mortgage holders, but remember, you never know what rates will do. There’s always the risk that if a fixed-rate raises suddenly, you could be left with a higher rate than you’d expected.
Understanding Mortgage Penalties
Mortgage policies vary between lenders, but the way prepayment penalties are treated is usually very similar. With fixed-rate mortgages, the penalty is usually the greater of the interest rate differential (IRD), or 3 months interest charge. In the case of variable rate mortgages, it’s almost always the 3 months interest charge, regardless of the length of time remaining in the term. Of course, always make sure you check with your lender beforehand to confirm that this is the case.
Fixed Or Variable Rate Mortgage: What’s Right For Me?
In certain market conditions, the choice between fixed or variable rates is clear, but when both rates are close together, it can be a tough decision. This is partly due to the fact that none of us can predict what will happen in the future and how economic conditions will change.
The best choice is the one that takes into account your personal situation. Think about it this way – if the mortgage you’re taking out is going to be in the upper reaches of your budget, or you tend to be highly risk-averse i.e., the idea of fluctuating interest rates causes you to lose sleep at night, then a fixed-rate mortgage is likely your best choice. On the other hand, if you have plenty of budget flexibility and don’t mind taking some risk to potentially benefit in a decreasing rate environment, odds are you can handle a variable rate mortgage.
Tom Drake is an authority in Canadian personal finance. He is a financial analyst and has been writing about personal finance since 2009 at the award-winning MapleMoney. His work has appeared in MintLife, Canadian MoneySaver, and U.S. News & World Report, and has been quoted in The Globe and Mail, Yahoo Finance, and Financial Post.