There are plenty of choices when it comes to purchasing a home: urban or suburban, condo or house, carpet or hardwood, just to name a few. Then there are the decisions about your mortgage; while most of us choose a ‘closed’ instead of an’open’ mortgage, it’s not always clear whether it makes sense to go with a’ fixed’ or ‘variable’ rate mortgage. It all depends. Let’s take a look at the difference between the two mortgage types to see which one makes the most sense for you.
Fixed Rate Mortgage
A fixed rate mortgage offers you peace of mind. You won’t have to fret about your mortgage rate going up as long as you’re “locked in.” That’s because your mortgage rate and payment remain the same during the term of your mortgage.
But there’s a cost associated with fixed rate mortgages. Mainly, you’ll pay a higher mortgage rate than variable rate. Also, usually, the longer you lock in, the higher your mortgage rate (i.e. a five-year fixed rate mortgage will have a higher mortgage rate than a one-year fixed rate mortgage).
A lot of first-time homebuyers go with five-year fixed rate mortgages. If you believe that interest rates are on the rise, going with a fixed rate mortgage makes a lot of sense (prime rate has already gone up twice this year). And in case you’re wondering, what influences fixed mortgage rates, it’s government of Canada bond yields, which are also influenced by U.S. government bond yields.
Something else to consider is your likelihood of breaking your mortgage during its term. Lenders typically charge a higher mortgage breakage penalty with fixed rate. Your penalty is calculated as the greater of three months’ mortgage interest or the Interest Rate Differential (or IRD for short). If you have to break your mortgage at some point in the future, your penalty could be quite hefty, so certainly consider that when going with a fixed rate mortgage.
Variable Rate Mortgage
Variable rate mortgages are different than fixed rate mortgages in several ways. Unlike fixed rate, your mortgage rate and payment amount aren’t necessarily the same during the term of your mortgage. Both could change depending on your lender’s prime rate. The only guarantee is the spread on spread (i.e. prime minus 0.8 percent).
Why would you go with a variable rate mortgage over fixed rate? Because you’ll usually pay a lower rate. If you believe interest rates are going to stay low or even fall in the next few years, going with variable often makes sense. But they’re not for the risk averse. Make sure you can sleep at night with the uncertainly of rates going up.
If you break your mortgage, the penalties are a lot simpler with variable rate. You’ll pay three months’ mortgage interest – that’s it. There’s no IRD to worry about.
You can also choose to lock-in at any time, although you’ll get what is called the “conversion rate,” which is usually a higher mortgage rate than you’d pay if you signed up for a fixed rate mortgage in the beginning.
Not sure whether to go fixed or variable? Contact our experts. We can weigh the pros and cons and help you decide what’s best for your personal financial situation.