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Choosing the the right mortgage can save you thousands of dollars throughout the course of your homeownership cycle. For example, a 1% increase in interest on a $300,000 loan over 25 years will increase your total payments by more than $39,000. When shopping around for a loan, one of the important decisions you’ll have to make is whether to opt for a fixed rate or a variable rate mortgage. The right choice for you will depend on your financial situation and your goals as a buyer. Let’s take a look at some pros and cons of each option: Fixed Rate vs Variable Mortgages – Which is Right for You?
Fixed-rate mortgages: pros and cons
In a fixed rate mortgage, the total amount paid by the borrower each month in principal payments and interest remains the same for the entire term of your mortgage agreement. Your interest rate will be negotiated with your lending institution, after which it’ll remain stable regardless of market and economic fluctuations. For example, if your bank offers you a 5 year fixed rate mortgage at a rate of 2.3%, you’ll pay off your mortgage at that rate for the next 5 years even if interest rates spike or plummet.
This type of mortgage is a popular choice amongst borrowers because it allows for predictable accounting. Essentially, it allows buyers to ‘set it and forget it’, bringing stability and peace of mind to their monthly budgeting.
On the other hand, fixed rate mortgages tend to come with higher interest rates, compared to variable rate mortgages. If the difference in rates between fixed and variable terms is significant enough, it may not be worth worth paying the additional cost for consistency.
A fixed rate mortgage is right for you if:
- You prefer the security of predictable budgeting from month to month, and are willing to pay a higher price for that security
- You are a risk adverse investor that enjoys the peace of mind of predictable cash flow payments
- You do not have a comfortable cushion of savings to fall back on if interest rates rise
- You are buying in a volatile market, where rates are subject to sharp spikes and drops
Variable-rate mortgages: pros and cons
On the other hand, a variable-rate mortgage is a loan in which the interest rate may fluctuate from month to month, based on global and local economic conditions. The rate is based on the lender’s prime rate, plus or minus a pre-determined percentage. For example, if your bank offers you a variable mortgage or “prime plus 0.5,” and the prime rate is 2.0%, you will be paying 2.5% until the prime rate changes. Prime rates are determined by the Bank of Canada’s overnight lending rate, which is further determined by the federal economy. When the economy is strong, rates will typically increase.
The advantage of a variable rate mortgage is that, examined historically, these loans are typically associated with lower interest rates than fixed mortgage loans. The difference in interest payments can yield significant savings for the borrower over the course of his or her mortgage term.
The main disadvantage of a variable rate mortgage is that borrowers cannot easily predict their mortgage charges from month to month. The financial uncertainty of potential increases in prime rates, interest rates and monthly financial burdens is unappealing to many buyers. In the worst case scenario, interest rates could spike up significantly and render the mortgage payments unaffordable, forcing the homeowner to sell the home or foreclose.
A variable rate mortgage is right for you if:
- You are comfortable with rate fluctuations, in exchange for possible long term savings
- You have the financial capacity to absorb possible increases to your amortization and interest rates
- You are buying or investing in a stable market with relatively predictable prime rates
Other mortgage considerations
Your downpayment amount – When buying a property in Canada, you’ll be required to make a minimum downpayment of 5%. Any downpayment amount under 20% is called a high-ratio mortgage, and is only applicable if the home is a primary residence, and costs under $1 million. With a high-ratio mortgage you’ll also need to pay for CMHC insurance, which protects the lender in case you default on your payment.
The premiums for CMHC mortgage insurance are as follows:
- 5%-9.99% downpayment : premium of 4%
- 10%-15.99% downpayment : premium of 3.1%
- 15%-19.99% downpayment : premium of 2.8
If you’re buying a rental property, you’ll have to apply for a conventional mortgage, with a downpayment of at least 20%.
Open vs closed mortgages – Lastly, you’ll have to decide whether your mortgage is open, or closed. In a closed mortgage, the more popular option, rates are typically lower but prepayments are limited. If you have extra savings one year and decided to pay off more of your premium, you’ll be charged a hefty fee. You’ll also be charged if you sell your home and break your mortgage early.
In contrast an open mortgage allows you to pay off your loan early without paying any fees. If you are anticipating large increases in your income and would rather pay off as much principal as possible, an open mortgage may be the better choice.
How to choose what’s right for you
All in all, your choice of fixed rate vs variable rate mortgage terms will depend on your objectives, the life stage you’re in, and your tolerance to risk. After doing your research, the first step is to speak to a reliable mortgage broker who can further guide you in the right direction and who’ll help you compare the long term savings on each available mortgage structure.
Fixed Rate vs Variable Mortgages – Which is Right for You