Variable vs Fixed Mortgage Rates
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A question many homebuyers are often conflicted about when buying a house is whether they should opt for a variable or fixed-rate mortgage. Depending on your financial circumstances, one will inevitably be better for you. Below, we’ll explain the differences between the two and how to choose between them.
What Is a Fixed-Rate Mortgage?
Under a fixed-rate mortgage, your payment amounts do not change over the length of the loan term. Your payments go toward paying off the principal and interest combined. And although the payment remains the same each month, the percentage of each payment that goes toward paying off the principal and interest varies with each payment as you pay down your mortgage. In fact, the two have an inverse relationship, where the interest paid will slowly decrease as the principal paid will increase.
To demonstrate this change in payments, below is a partial amortization table of a mortgage of $300,000 for 30 years with an interest rate of 4.2%.
|March 20, 2020||$1,467.05||$1,050||$417||$299,583|
|April 20, 2020||$1,467.05||$1,049||$419||$299,164|
|May 20, 2020||$1,467.05||$1,047||$420||$298,744|
|June 20, 2020||$1,467.05||$1,046||$421||$298,323|
|July 20, 2020||$1,467.05||$1,044||$423||$297,900|
How Is a Fixed-Rate Determined?
Fixed mortgage rates are determined based on the prime rate and the economic climate at the moment your loan contract is created. Therefore, the interest rate during your term will always remain the same regardless of how the economy and prime rate are doing a few years later.
In general, banks and lenders base their rates on the Bank of Canada benchmark rate. The benchmark rate is a rate that banks and lenders must adhere to when qualifying borrowers for mortgages in Canada. The reason being, the government wants to make sure people will be able to handle any market volatility. So, often you will find that the benchmark rate is about 1.5% higher than the best rates in the market.
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Pros and Cons Of a Fixed-Rate Mortgage
Though the cost of borrowing a mortgage on a fixed rate tends to be a little higher than borrowing on a variable rate there are still several advantages.
There is no risk as any increase in the interest won’t affect you. You will be making the same payments every month regardless of what factors may change the economic state and thus rate. If you have to adhere to a strict budget and do not have the financial security and flexibility to make varied payments, a fixed rate is good for you.
Though a fixed rate is a less risky option, it can be more expensive in terms of interest. Higher interest rates can make payments less affordable. When that happens borrowers may extend the term length to make the payments more affordable which results in more interest paid over the length of the term.
What is a Variable Rate Mortgage?
A variable rate mortgage varies and changes with the prime rate. When the prime rate is adjusted based on economic factors the variable rate on your mortgage loan will be adjusted as well. Therefore, your payments can be constantly changing based on economic factors.
How is a Variable Rate Mortgage Determined?
The variable rate is determined using the prime rate of Canada. It fluctuates with the prime rate and will change every time the prime rate fluctuates. The prime rate is an interest rate that major banks and financial institutions use as a measure to set their rates for different credit products. It is influenced by the overnight rate set by the Bank of Canada, which is shaped by the cost of borrowing for the major financial institutions in Canada. Often rates will be advertised as 3.95% with prime – 1.20% written underneath it. This translate to prime rate (5.15%) – discount rate (1.20%) = your interest rate (3.95%).
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Pros and Cons of a Variable Mortgage Rate?
If you go with the variable rate you stand to save more money in comparison to a fixed rate depending on what’s happening with the prime rate from the central bank. This is because as the prime rate lowers, the interest rate on your mortgage lowers. When the prime rates lower, so does the variable rate meaning more money can go toward paying off the principal. The more money that goes into the principal, the less you pay on interest and the faster you can pay off the mortgage.
However, if the prime rate goes up, the interest rate on your mortgage will go up as well. People who go for variable-rate mortgages need to have the financial stability to be able to handle this risk. If there is no need to adhere to a strict budget a variable rate mortgage may be good for you.
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Which Loan Rate Do I Choose?
When choosing between a variable and fixed-rate mortgage, you must consider a number of personal and economic factors to see which of the two works best for you. If interest rates are fairly low and you don’t expect it to fall further during your loan term then locking in a fixed rate is advisable. On the other hand, if you expect the rates to fall, a variable rate may be more preferable. However, do not forget that no one can 100% accurately predict how mortgage rates will change over time so be wary of the information you get.
Aside from economic factors, you must also consider your own financial situation. Are you able to afford a sudden rise in payments if interest inflates? If not, the stability of a fixed rate will suit your needs more. However, if you are able to keep up with sudden changes, a variable rate may be worth it for the potential drops in interest.
Pro Tip: Lock Your Rate in Advance When it’s Time to Renew
One of the best strategies somebody with a mortgage can take on is to lock down a mortgage rate well before the mortgage term ends. This can protect you from a short term rate increase and will let you evaluate which term is right for your next mortgage cycle early on. Many lending institutions now provide rate-locks of 3, 4 and up to even 6 months – so taking advantage of this is a no-brainer.
Whatever rate you choose will have to work well with your financial lifestyle, if you’re at a point financially where taking some risk is feasible, a variable rate mortgage could be the way to go. If you are risk-averse and prefer to make the same payments every month stick to a fixed-rate mortgage. In the end, whether you go for a variable or fixed-rate mortgage, your bank will able to help you choose what suits you best.
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