People always ask me whether they should get a fixed or variable rate mortgage. Your focus should not only be on getting the lowest interest rate, but also what your plans are during the term of the mortgage, and what your comfort level is with monthly payments.
Buying a home is one of people’s biggest life decisions and knowing the difference between a fixed and variable rate mortgage is important in the long term.
Fixed and variable mortgage rates are very different in terms of how they are funded. Fixed mortgages rates follow the patterns of Canada Bond Yields, plus a spread, where the bond yield is driven by economic factors such as inflation, unemployment and exports. The bonds are purchased by a mortgage lender, are sold as a mortgage to a borrower and then re-sold as an income-based security back to the financial market.
Variable mortgage rate products are based on the prime lending rate. This is a fluctuating yard stick used by the Bank of Canada to determine borrowing rates on all loans in Canada. The rates are driven by the same economic factors, except variable rates fluctuate with the movements in the prime lending rate, the rate at which banks lend to their lower credit risk clients. When inflation is high, the Bank of Canada will increase the prime rate to make the borrowing of money more expensive. When inflation is low, the Bank of Canada will decrease the prime rate to stimulate the economy and encourage borrowing of money.
Before the new mortgage rules that came into effect last October, most borrowers chose a fixed rate, as the qualification requirements were based on the contract rate compared to qualifying at the Benchmark of Canada for a variable rate. Now, when you pay less than a 20% down payment, you are qualifying at the Benchmark of Canada (currently at 4.64%) regardless of whether you select a fixed or variable rate. When you put more than 20% down payment, if you select a fixed rate you qualify on the contract rate and for a variable rate you qualify at the Benchmark of Canada.
Now, what is the difference between a fixed and a variable rate?
Fixed rate: The fixed rate is usually higher than the variable rate. The interest rate will remain constant or fixed for the term of the mortgage which means your mortgage payments will remain the same throughout the term.
Variable rate: A variable rate can change during the term of the mortgage which means your actual mortgage payments can either increase or decreased during the term of the mortgage.
A variable rate can be a higher risk for some clients as rates can go up which will affect your mortgage payments. In the last few years, rates have generally decreased and many borrowers have taken advantage of the variable rate and subsequently have not seen an increase in mortgage payments. However, that doesn’t mean that the variable rate can go up at anytime.
The great thing about a variable rate is that you have the option to lock into a fixed rate at any time if you start to feel uncomfortable with a payment increase. While your interest rate will not double overnight and even if it did go up by 0.25%, the savings you would have already earned would put you on a level playing field. If you decide to switch from a variable to a fixed rate, the fixed rate will be determined based on what the fixed rate is at that time for the remainder of your term.
Variable rates are offered based on the prime rate and either at a premium or at a discount. While the discount remains the same during the term of the mortgage, the prime rate may go up or down. Which means that variable rates are based on the Bank of Canada who sets the benchmark for interest rates, based on inflation. Currently the benchmark rate for the Bank of Canada is 2.50%. But most lenders are using 2.70% as its Prime rate except TD Bank that has their current mortgage Prime rate at 2.85%. For example, a lender might offer you Prime -0.35% (2.70% - 0.35% = 2.35%) which means that if the Bank of Canada or the lender increased their prime rate your discount will remain constant yet your mortgage payments will increase. It’s good to know that Bank of Canada reviews its benchmark rate about 8 times a year. Depending on the state of the economy, they may decide to raise or decrease the benchmark rate which will affect your variable rate.
Another big difference between a fixed and a variable rate is how the penalty is calculated should you get out of the mortgage early and the lender that holds your mortgage.
If you have a variable rate, the maximum you would most likely pay a three-month penalty interest. However, if it is a fixed mortgage, you will pay the greater of either the Interest Rate Differential (IRD) or three-month interest.
The IRD is calculated by determining the difference between the mortgage rate in effect and the rate available at the time of the pre-payment, multiplied by the term remaining on the mortgage. The interest rate differential is meant to compensate the lender for having the mortgage paid early. Most lenders have different ways of calculating their pre-payment penalties, therefore, it is critical that you find out how they will be calculated upfront before signing your mortgage, even more so if you think you might need to get out early.
A Mortgage Expert can help you determine if a fixed or variable rate based on your individual needs.
It is also important to note that if you decide to go for a variable rate, there are some technical terms that you should be aware of such as adjustable rate mortgage (ARM) and variable rate mortgage (VRM). While they are both tied to the Bank of Canada prime rate, they are some very important differences between the two.
With a variable rate (VRM) your mortgage payments will remain the same if prime rate goes down, so you will be paying more towards principal and if prime rate goes up you will be less of principal and your amortization period will extend.
With an adjustable rate (ARM) it is almost the same as a variable rate except for the fact that if prime rate moves up or down, your mortgage payments will adjust along with the prime rate.
Therefore, it is critical that you confirm if your variable rate is adjustable or not.