Here are the differences between a fixed-rate and variable-rate mortgage.
Fixed Rate Mortgage
A fixed-rate mortgage is one in which the interest rate is fixed for a period of time – usually between 1 and 5 years, although some lenders offer longer terms. The borrower pays the same amount (interest plus principal) for the term of the mortgage.
Fixed-rate mortgages are the most popular mortgage type obtained by Canadians, accounting for about 66% of all mortgages. Some of the reasons for the popularity of fixed-rate mortgages include:
- Ease of budgeting and financial planning since your mortgage obligations are predetermined for the entire mortgage term
- Protection against a rise in interest rates
A downside to fixed-rate mortgages is that the interest rate is usually higher than that of variable-rate mortgages for comparable terms. You may also have to pay more in penalties for breaking your mortgage.
Related: Best Mortgage Rates in Canada
Variable Rate Mortgage
With this type of mortgage, the interest rate of the loan fluctuates with the prime rate set by the lending institution. The prime rate is the rate set by major lending institutions for their variable loans, mortgages and lines of credit. This prime rate closely mirrors the overnight rate set by the Bank of Canada and reflects the cost of borrowing money by the bank.
Although payments usually remain unchanged throughout the mortgage term, the proportion of mortgage payment applied towards principal and interest will vary as the interest rate varies. Historically, studies have shown that variable-rate mortgages save homeowners money in the long run. Using data from 1950 and 2007, Dr. Milevsky showed that the average Canadian can expect to save interest about 90% of the time by choosing a variable rate mortgage instead of a fixed one.
Other advantages of a variable rate mortgage include:
- If rates fall, the borrower will benefit from paying off more of their principal loan
- It is cheaper to break a mortgage (penalty is three month’s interest payment)
Downsides to a variable rate mortgage include: mortgage obligation is less predictable due to fluctuating interest rates and there is a higher short term risk.
Open vs. Closed Mortgages
This refers to a mortgage that can be paid off either in part or in full at any time before the end of the term without incurring pre-payment charges. You can also change the terms of the mortgage. If you have plans to pay off your mortgage in full within a very short period, this may the appropriate mortgage-type to go for. Interest rates are usually higher than for a closed mortgage.
Prepayment options are limited for a closed mortgage and payments beyond what is permitted under your mortgage contract will result in prepayment charges. This is the more common type of mortgage because most people are not able to pay off their mortgage lump-sum or within a short duration. Usually, this type of mortgage still comes with some room to make limited prepayments such as increasing your monthly mortgage payment amount by 20%, etc.
Related: What to do When Mortgage Rates Rise
Conventional vs. High-ratio Mortgages
This is also known as a traditional mortgage and refers to a mortgage where the buyer puts down 20% or more of the purchase price of the house as a down payment. Because the loan-to-value ratio is lower, a conventional mortgage is usually not required to obtain mortgage default insurance.
This is a mortgage in which the buyer has a down payment of less than 20% of the value of the home and has to pay for mortgage default insurance. The amount of mortgage insurance required varies depending on the percentage of down payment (currently anywhere from 1.8% to 3.6% premium – increased in March 2017).
Other Mortgage Terms
This refers to a mortgage that can be transferred from one property to another without incurring penalties. For example, when you are selling your current house and purchasing a new one. It may be important to have this option included in your mortgage contract if you think you may need to change houses or relocate during the term of your current mortgage. Alternatively, you can just choose a shorter term.
The feature comes in handy if your current interest rate is lower than the prevailing rates at the time you are purchasing a new home.[bctt tweet=”Mortgage porting clauses may vary with different lenders, so read the fine print!” username=”SavvyCanadians” prompt=”Tell A Friend” nofollow=”yes”]
This is a combination of a fixed and variable mortgage. A portion of the loan is set up at a fixed interest rate while the other portion is set up at a variable interest rate. This type of mortgage is not as popular with Canadians.