Buying a home is an exciting time! Of course, it can also be very complicated and there are lots of “i’s” to dot and “t’s” to cross. One of the first things new homebuyers must do is decide whether to choose a fixed rate or a variable rate mortgage. Of course, some homebuyers, especially first-timers moving out of their parents’ home or finally saying goodbye to renting, may not even be sure what the difference is.
So, before diving into the pros and cons of a fixed rate vs. variable rate mortgage, 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?
A fixed rate mortgage means that the interest rate of the mortgage will remain the same until the mortgage comes up for renewal.
Fixed rates are based on the Government of Canada’s bond yields at the time of purchase, and doesn’t change even if the bond yields do. 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. It is determined by the Prime Rate which 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.
The prime rate in Canada is currently 4.70%. The prime rate, also known as the prime lending 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.
A variable rate mortgage is set at prime plus/minus a discount or premium. So, let’s say you’re given a mortgage rate of prime – 1.00%. 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.
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.
Fixed and Variable Mortgage Rates Compared
Fixed Mortgage Rate
Description: Set for the duration of the mortgage term. Mortgage interest rate and payments are fixed.
Pros: Can essentially ‘set it and forget it’, regardless of whether rates rise or fall. Eases budgeting anxiety and offers stability. Rate is typically a bit higher, but provides for a stable, consistent mortgage payment for years to come.
Cons: If the difference between the variable and fixed rate is significant, it may not be worth paying a premium for the stability protection of a fixed rate. If you break the mortgage, there is often a bigger penalty called an Interest Rate Differential Penalty.
Variable Mortgage Rate
Description: Fluctuates with the market interest rate, known as the prime rate. Mortgage payments either fluctuate with fluctuations in the prime rate, or the interest portion of the payment varies.
Pros: Examined historically, variable rates have proven to be less expensive over time. If you break the mortgage, the penalty is typically far lower. You can lock the variable rate into a fixed rate at any time, without breaking the mortgage.
Cons: Consider the financial uncertainty: significant increases in the prime rate will increase your interest payable and, thus, financial burden.
The Bottom Line
While it’s crucial to take into account whether you would benefit more from a fixed or variable rate mortgage, that isn’t the only factor to consider when determining the best mortgage solution for you. It’s important to speak with a mortgage broker you can trust to help you make the right decision. Give me a call at 780-288-0643 and let’s review your options to see what makes the most sense.
Tatum Neufeld, BComm
Mortgage Broker • Mortgage Tailors