One may offer peace of mind; the other could help you stockpile
How does a fixed-rate mortgage work?
For a fixed-rate mortgage, your mortgage payments and the interest rate stay the same throughout the duration of your mortgage term. If interest rates remain the same, you will know for certain when you will pay off your mortgage, meaning you will be confident that you know what to budget for your mortgage payments, making planning your budget much easier.
(If, however, interest rates go down during the period you are locked into a fixed-rate term, you may miss out on possible savings.) For these reasons, fixed-rate mortgages are easier to understand than variable mortgages.
The downside to a fixed-rate mortgage is that interest rates are often more expensive than a variable-rate mortgage—and you are locked into that interest rate for the whole mortgage term (in Canada, a term is typically five years).
Plus, you are not able to switch to a variable rate without breaking the mortgage, and if you break the mortgage, penalties are likely to be higher than with a variable-rate mortgage. The penalty that comes from breaking the mortgage is called the Interest Rate Differential (IRD) Penalty.
How does a variable-rate mortgage work?
For a variable-rate mortgage, on the other hand, your payments will remain consistent throughout the mortgage term but the interest rates can fluctuate, as can the prime interest rate. For a variable-rate mortgage, the initial interest rate is usually lower than a fixed-rate mortgage, and an initial lower payment could help you qualify for a bigger loan.
The prime rate may fall, and your interest rate with it, meaning a higher percentage of your payment will be freed up for the principal. Another benefit for a variable-rate mortgage is that, at any time, it can be converted to a fixed-rate without breaking the mortgage, making it more flexible. Plus, if you break the mortgage, the penalty usually is not as high.
One concern with a variable-rate mortgage is that the amortization period may be lengthened if the prime rate rises, lowering your interest rate, meaning less of your payments will be go toward the principal.
It is important to note that a variable mortgage rate is based on a mortgage lender’s prime rate—and changes accordingly. Put another way, your mortgage rate rises and falls with the prime rate.
What is “prime”?
Major banks use “prime” as a benchmark interest rate when pricing for short-term loans. Capable of fluctuating on a monthly basis, prime is directly influenced by the overnight lending rate of the Bank of Canada (BOC). Changes to the prime lending rate and the Bank of Canada’s overnight lending rate depend on the Canadian economy and inflation forecasts. The BOC, over the past 25 years, has changed prime lending rates – by either 0.25% or 0.50% – six times on average per year (which directly impacts prime rates).
The interest rate you pay on variable-rate mortgages is directly linked to the prime rate and will rise and fall with it; more of your payment will go toward the principal if the prime rate drops—meaning you pay off your mortgage more quickly.
But more of your payment will go into the interest, and less to the principal, if the prime rate rises. That means it may take longer to pay for your house. On the other hand, your lender could increase payments to make sure you pay off the mortgage by the end of the amortization period if the prime rate rises to a specific percentage, otherwise known as a trigger point, which will be listed in your mortgage contract.
Why can variable-rate be more appealing during this time?
Due to the impact of the omicron coronavirus in 2022, variable-rate mortgages may be the best bet during this time, even though fixed rates are a fantastic solution for many and their rates are still quite low. In an attempt to stimulate the economy, the Bank of Canada will likely not increase variable interest rates too much, too quickly, until it is the economy is back on track for long-term, sustainable growth—after COVID.
By keeping interest rates low, the Bank of Canada makes borrowing more attractive so that Canadians borrow more and spend more, thus boosting the economy. It also reduces the amount of money borrowers have to spend on interest, freeing up money to spend elsewhere in the economy. The bottom line here is that variable rate is typically lower than fixed and you can lock a variable rate into a fixed at any point, without breaking the mortgage, making it an ideal time to opt for variable rate.
Fixed-rate can be another way to go
For fixed-rate mortgages, “peace of mind” may be priceless. Fixed-rate mortgages allow you to lock in to a predetermined rate set for a term—the most popular term in Canada being five years.
You will also know what monthly payments each month for the remainder of the term will be, providing you with a bit more security and comfort. A fixed-term mortgage arguably makes budgeting and financial planning much easier; but if interest rates drop during your term, you may miss out on potential savings.
Analyse which rate is right for you
It is important that you weigh the pros and cons of both a fixed-rate and variable-rate mortgage compared with your situation, your personal tolerance, and the mortgage market. It may come down to understanding that, a lot of the time, security has a price—the question is how high. If you are trying to decide between a fixed-rate or variable-rate mortgage, a mortgage expert can help you analyze which will work best for your current situation.
