With the ever-changing interest rates and housing market, you might be left wondering whether you should choose a fixed or variable rate mortgage on your next home purchase or mortgage renewal.
So, before diving into the the differences between the two, let’s be sure we’re on the same page about what exactly they are with some basic definitions.
What is a fixed rate mortgage?
The name says it all. A fixed-rate mortgage means that the interest rate of the mortgage will remain the same for the entire length of your term, so until the mortgage comes up for renewal. Your term is the length of your mortgage contract.
Therefore, there are no surprises with a fixed-rate mortgage. You know how much of your mortgage payment will go toward interest and how much will go toward your principal for the length of the term.
What is a variable rate mortgage?
A variable-rate mortgage means that the interest rate of the mortgage will fluctuate throughout the term. Your mortgage rate is set at your lender’s Prime Rate +/- a discount or premium. Simply put, as the Prime Rate fluctuates over the term, for better or worse, the interest rate on your mortgage will fluctuate too. Though the Prime Rate may fluctuate, the relationship to Prime will stay constant over your term.
It’s important to distinguish between the two types of variable-rate mortgages. There’s ARM and VRM. Both are very similar, however, there’s a key difference to be aware of.
Adjustable Rate Mortgage (ARM)
An adjustable-rate mortgage is the most common type of variable-rate mortgage. As the lender’s Prime Rate changes, so does your mortgage payment. If the Prime Rate increases during the term, so does your mortgage rate and therefore your mortgage payment. The Prime Rate decreases, then the opposite is true.
Variable Rate Mortgage (VRM or VIRM)
A variable rate or variable interest rate mortgage is when your regular payment is static, meaning it does not change when the Prime Rate changes. However, a change happens behind the scenes—the interest portion of the payment changes. If Prime goes up, more of your mortgage payment will go towards interest and less towards principal, and vice versa.
As interest rates on variable rate mortgages increase and the payments don’t change, there will be a point where the principal and interest payments can no longer cover the interest charged on the mortgage. This happens when your rate has exceeded the Trigger Rate.
The Trigger Rate is the rate at which the regular mortgage payments no longer covers the accrued interest. Interest rates for the variable rate increased so much that the entire payment is dedicated towards the interest and nothing towards the principal. If rates were to increase anymore, the payments no longer cover the interest. When this happens, you have to increase your payment, make a lump sum and/or switch to a fixed rate with a higher payment.
What is causing mortgage rates to change?
Variable Mortgage Rates
Variable rates are determined by the Prime Rate, also known as the prime lending rate. The Prime Rate is the annual interest rate Canada’s major banks and financial institutions use to set interest rates for variable loans and lines of credit, including variable rate mortgages.
The Prime Rate is based on the Bank of Canada’s overnight rate and has the potential to go three directions at any one of the eight Bank of Canada meetings per year; either rise, fall or remain constant. Basically, if the overnight rate increases, so does the Prime Rate and therefore, variable rate mortgages.
The overnight rate is adjusted according to the economy and inflation rate. The stronger the Bank of Canada expects inflation and the economy to be in the coming months, the higher the overnight rate will be to curb inflation and bring it back to the Bank’s 2% target.
Fixed Mortgage Rates
Fixed rates are influenced by long-term Government of Canada bond yields. For example, fixed mortgage rates for a five-year term vary in relation to a five-year Canadian bond rate, which are influenced by long-term economic and inflationary forecasts.
How to decide which is right for you?
When to select a fixed-rate mortgage:
- You’d rather budget for predictable and consistent payments, generally with the same principal-to-interest ratio, regardless of market fluctuations.
- If the current economic conditions are keeping you up at night, select a fixed so you can essentially ‘set it and forget it’ to help ease budgeting anxiety and offer stability.
- If extra mortgage costs would break your budget, then locking in a fixed rate mortgage might be a smart strategy.
- A fixed rate mortgage insulates home buyers and renewers against further rate hikes for the length of the term, but the risk is that those monthly payments won’t drop if rates decrease over time, as they would with a variable rate mortgage.
- You’d still like the stability and security of a fixed-rate mortgage, but perhaps for a shorter two- or three-year fixed to let the market correct over the next few years and avoid a potential penalty of a five-year fixed.
When to select a variable-rate mortgage:
- You want to take advantage of a lower rate from the start and potential rate decreases during your term. Examined historically, variable rates have proven to be less expensive in the long run compared to fixed.
- Your budget can handle an increase in your monthly payments or a reduction in the principal repaid in the event of rate increases.
- You don’t plan to stay in the home for five years, meaning you will likely sell before the end of the term then choosing a variable rate mortgage makes sense due to paying only a three-months interest penalty. As soon as you break a fixed-rate mortgage, you will be charged an Interest Rate Differential (IRD) penalty which can be tens of thousands of dollars to break the mortgage.
- Has significantly lower payout penalties if you need to break your mortgage contract to refinance in the future to take out equity for investment opportunities, home renovations, children’s education, etc..
- You plan to pay down your mortgage quickly or more aggressively.
- You want the flexibility to switch to a fixed-rate mortgage anytime during your term.
A tip for peace of mind: While looking for a home, you can secure a rate against possible increases with a mortgage pre-approval. It will also help you simplify your buying process by determining your borrowing power, especially when it comes to making an offer to purchase.
The Bottom Line
The choice between fixed and variable will depend on the economic situation, your personal finances, and risk tolerance. Like all financial products, each case is unique. If you’d like to evaluate your personal situation, connect with me today.
Tatum Neufeld, BComm
Mortgage Broker • Mortgage Tailors