First-time home buyers and homeowners who are back in the market to renew their mortgage loan, have to make a decision on whether to obtain a variable or fixed rate mortgage. The ramifications of this decision can be significant, because it can impact your budgeting, standard of living, and finances in general.
To start, let’s define variable and fixed rate mortgages.
Fixed Rate Mortgage
A fixed rate mortgage is one where your mortgage payments are fixed and remain the same throughout your mortgage term. For example, if you have selected a 5-year fixed rate mortgage and your monthly mortgage payments are $2,000. This means that you will be paying $2,000 every month for the next 60 months (5 years).
Changes in interest rates or prime lending rates will not impact your monthly payments one way or another – payments will stay consistent for 5 years.
Variable Rate Mortgage
This type of mortgage can fluctuate during the mortgage term depending on fluctuations or changes to the prime lending rate set by your lender. Basically, when interest rates fluctuate, your payment fluctuate as well. This could mean that your overall payment amount changes, or it may stay the same and the change will be reflected in the proportion of your payment that goes towards paying down your loan’s principal vs. interest.
For example, when the banks’ prime rate goes up, your variable mortgage rate increases. Depending on how your mortgage is set up, this can result in an increase of your monthly mortgage payment, or more commonly, your payment will stay the same, but a greater proportion of it will go towards paying off interest.
Variable or Fixed Rate Mortgage?
Some factors you should consider when deciding on whether to go with fixed or variable rate mortgage include:
1. Peace of Mind and Stability
There is a good reason why more than 60% of all residential mortgage loans in Canada are fixed rate mortgages. New homeowners often want the peace of mind that comes with knowing exactly what they are on the hook for each month to cover their mortgage obligations. They don’t want any surprises and are willing to pay slightly more for the assurance (or insurance) that there will be no increases in their payment amount for the term of the mortgage.
Even though a variable rate mortgage will be cheaper at the time of closing, and may even fall further over time, the issue here is risk of the unknown. And as rational beings, the majority of people are risk-averse…they want to be able to sleep well at night.
If you are working with a tight budget and can’t afford any surprise changes to your budget or find extra cash at short notice, a fixed rate mortgage may work better for you. With a variable mortgage, you cannot reliably predict what will happen…or what the prime lending rate will be in say 6 month from today.
3. Ease of Mortgage Approval
Depending on your financial situation, how much you are putting down as down payment, and if you are a low or high-ratio borrower, it may be easier for you to get approval for a fixed rate mortgage, than a variable one. Depending on your loan-to-value ratio, the variable rate you are offered may differ.
So, if your income means you will find it difficult to absorb a rate hike that significantly increases your payments, a fixed rate mortgage may be preferable.
4. Historical Data – Variable Rates Win
Historically, you will save more by paying less interest over time when you choose a variable rate. One study that highlights this is the one by Dr. Milevsky. Using data from 1950 to 2007, he showed that homeowners can expect to pay less interest about 90% of the time by choosing a variable rate mortgage over a fixed one.
There are other studies that support this claim. What this means is that if you are financially stable and have extra funds you can deploy to cover sudden increases in interest rates, a variable rate can potentially save you thousands of dollars over the life of your mortgage.
5. Rate Spread vs. Potential Savings and Risk
Another important factor to consider is the spread between variable and fixed mortgage rates. In the past, the difference between fixed and variable mortgage rates for similar durations was usually in the 1% plus range. However, after the financial crises and prolonged periods of low inflation, interest rates collapsed resulting in the lowest mortgage rates we have seen in decades.
When we were looking to take on a mortgage in 2016, 5-year fixed mortgage rates were between 2.54 – 2.64%, while variable mortgage rates were between 2.25 and 2.35% – a spread of roughly 0.3%. With such a thin spread between variable and fixed rates, fixed rate mortgages become more attractive, because you are now paying much less for the insurance of having fixed and stable payments.
When fixed and variable rates diverge and the spread between them increases (> 0.5%), variable rates start to become more attractive.
6. Penalties – Planning to Move or Sell?
The penalties incurred when you break a fixed rate mortgage is usually much higher than for a variable rate mortgage. If you know that you may need to move or sell your home before the end of the common 5-year fixed mortgage term, you should consider a shorter fixed rate term or go with variable. In addition, you can choose a mortgage that has favourable portability options.
Breaking or renegotiating a variable mortgage will cost you about 3 months in interest payments. Whereas, for a fixed mortgage, you can expect to pay the greater of 3 months’ interest or the interest rate differential – this is often more costly.
7. Mortgage Amount
If you are putting down a hefty down payment, or are renewing a mortgage and have a low mortgage balance, the risk you face from sudden spikes in interest rates is much lower. In this case, a competitive variable mortgage rate can be very attractive and would also be easier to qualify for.
8. What’s On Offer?
Even within the same mortgage-rate type (i.e. fixed vs variable), there can be significant differences. This is why it’s important to look closely at the small prints, and ensure that features tagged onto your mortgage loan are precisely what you need.
Features like portability (ability to move your mortgage to a new property), prepayment (ability to put in extra payments towards paying down your mortgage) etc., may be widely different and impact your choice.
The regime of low-interest rates appear to be turning. The Bank of Canada announced 2 rate hikes in 2017 (to 1%) and have already announced a further increase on January 17, 2018 (to 1.25%). This is the highest we have had the overnight lending rate since the financial crises of 2009. Analysts are predicting that there will be more rate hikes in 2018 – of course, predicting the future of interest rates is mostly a guessing game!
When we closed our mortgage in 2016, interest rates appeared to have bottomed out and the spread between fixed and variable mortgage rates was very small. Also, as new homeowners, we wanted to have some insurance against any sudden changes in interest rates and intended to stay the in the house for at least 5 years before moving (if at all). As such, we went with a 5 year fixed mortgage.
If rates continue to go up as they are doing right, its more likely that when we have to renew our mortgage, we will be going for shorter-term variable rates.
Buying a house soon and looking for the lowest mortgage rate possible? check out IntelliMortgage for the best mortgage rates available in your area!
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