One of the biggest decisions you must make when taking out a mortgage is choosing between a fixed and variable interest rate. This may seem like an easy choice, but there is no "right" answer. A fixed rate mortgage, which is the most common option, offers the predictability of a monthly payment that remains the same for the life of the loan. A variable interest rate, on the other hand, generally starts with a much lower interest rate and the potential for greater rewards.
Whether a loan is fixed or variable refers only to how interest is calculated and applied to your balance; open and closed mortgages refer to the flexibility you have in paying off your loan.
You can protect yourself and ensure your home will remain affordable by choosing the best possible loan option today that also considers what may happen in the next five years or so. Here's what you should know about variable and fixed mortgages when calculating your next home purchase.
Fixed Rate Mortgages: Security and Predictability
With a fixed rate loan, you will be locked in to the same interest rate for the life of the loan. This offers a great deal of stability in terms of your rate and payment. Every month, you will know exactly how much interest and principal you'll pay.
Another benefit is you can be sure you'll always be able to afford your mortgage payment, assuming there are no significant changes to your income. The downside? You can't take advantage of falling interest rates or the ability to put more of your payment toward principal.
Another downside of a fixed rate mortgage is the pre-payment penalty. This penalty is charged if you end your mortgage early and is usually the interest on the remaining balance or three months of interest - whichever is greater. Variable rate mortgages also come with pre-payment penalties, but it's usually less than the fixed rate penalty. Most buyers who get a five-year mortgage end up paying it off at least a year early so this is something to keep in mind.
The bottom line: With a fixed rate, you can lock into today's low-interest rates, which are unlikely to get much (or any) lower in the next few years. The trade-off is a higher pre-payment penalty and an inability to take advantage of dropping rates.
Variable Rate Mortgages: Higher Risk and Reward
Home buyers have historically hesitated on variable loans due to the potential risk of rising rates, but this has changed in recent years due to low borrowing costs. This risk comes with a potentially greater reward: variable rate home loans usually offer the lowest rates available to start. In addition, if interest rates drop, a greater amount of your monthly payment goes toward your principal balance to pay off your mortgage even faster.
Variable mortgage rates can change at any time based on market conditions. These rates are based on the Bank of Canada prime rate minus a discount. If the prime rate goes up based on changes to the overnight rate, the variable rates will go up. In most cases, rate changes don't occur more than once each month, but it means your rate can change monthly. Your monthly payments will remain the same, but the amount applied toward principal changes as the rate changes.
These loans also have an early renewal feature that lets you lock into current fixed terms at any time to convert your mortgage if necessary. This offers a bit of a buffer if rates start to increase and you decide a fixed loan will be a better option.
Variable mortgage rates may be about 0.5% lower than fixed rates, on average. While this may not seem like a big difference, it can save you over $30,000 in interest over the life of your loan. You can put that $30,000 toward paying down your principal or contributing to your retirement to further increase your savings.
The key to determining if a variable rate loan will work for you is deciding whether the loan will still be affordable if rates increase. Keep in mind mortgage rates remain at historic lows, so there's a very good chance rates will increase within the next few years. If you can comfortably afford the loan even if rates go up, a variable rate loan may be a good fit; use a mortgage calculator to determine what your monthly payments might look like.
The bottom line: A variable rate mortgage can potentially save you tens of thousands in interest, but rising interest rates have the potential to offset anything you save.
Which Loan Option is Best?
A fixed rate mortgage may be the best choice for you if you have a large mortgage, expect to have a high balance in five years, would find it difficult to make additional monthly or lump-sum payments, or want to avoid the uncertainty of fluctuating interest rates.
If you are getting a smaller loan, have no difficulty making additional payments, or you do not plan to live in the home for more than five years or so, a variable rate mortgage may be the better option.
In order to make the best decision, speak to your builder's preferred lender. Not only can they help you determine which mortgage is best for you, but you may benefit from some great concessions along the way!