Fixed Rate Mortgage Vs. Variable Rate Mortgage
Choosing between a fixed rate mortgage and a variable rate mortgage is one of the biggest decisions a borrower will have to make when applying for a mortgage. After all, the choice they make could affect their finances for several years. Fixed and variable rates exist so that borrowers have the freedom to determine what works best for them. However, each option comes with its own set of advantages and disadvantages, and trusted mortgage broker Boychuk Mortgage Group would like to shed some light on both to help borrowers make suitable decisions.
What Is A Fixed Rate Mortgage?
A fixed rate mortgage is a mortgage where the rate of interest charged remains the same for the entire term of the mortgage. Even if the interest rates in the market fluctuate, the interest owed on a fixed rate mortgage will stay the same every month during the term of the mortgage. The duration of a fixed mortgage can be anywhere from six months to ten years. It all depends on the lender providing the mortgage. That said, a fixed rate is much higher than a variable rate. But usually, a shorter mortgage term ensures a better fixed rate. On the other hand, a longer term will equal a higher interest rate. Borrowers usually go for a fixed mortgage rate when they are looking for consistency and want to play it safe.
What Is A Variable Mortgage Rate?
A variable rate mortgage is one where the interest rate changes based on a mortgage lender’s prime rate. Each mortgage lender sets their own prime rate but usually follows the Bank of Canada’s policy interest rate or the overnight rate. Should the Bank of Canada increase its target policy interest rates, the prime rate of lenders will increase too. This, in turn, will cause variable rates to increase as well.
Apart from the prime rate, a variable interest rate is also influenced by the borrower’s financial situation. For example, the rate may be prime + 1%, where the prime rate is 2.45%. In this case, the variable rate would be 3.45%. But, if the rate is at a discount compared to prime, say prime - 1%, then the variable rate would be 1.45%. That said, while the variable rate may change, the discount or premium against the prime rate will stay the same.
Fixed Vs. Variable Mortgages: A Comparison
Fixed mortgages have a stable interest rate that never changes throughout the duration of the mortgage. That means that borrowers don’t have to worry about revising the amount of money they have to repay their lender every month. The downside is that fixed rates are expensive, and they do not provide any benefits when the interest rates go down. Also, there is a high mortgage prepayment penalty, and a fixed rate can not be converted into a variable rate.
Variable rates are usually much cheaper and highly suitable for those who don’t mind the uncertainly associated with rate changes. Moreover, these rates can save a significant amount of money when they are low or if they fall even more during the term of the mortgage.
Let’s assume the fixed rate is 3% and the variable rate is 2%. If the variable rate is 2% for three years, then increases to 3%, and then 4% in four years, a borrower would have saved more money with this rate than a fixed rate. The year when the variable interest rate exceeded the fixed rate would have been offset by the savings from the previous years.
Another benefit of variable rate mortgages that is worth noting is they have lower mortgage penalties. With a variable rate, mortgage prepayment penalties generally cost only three months of interest. With fixed mortgages, the penalties tend to be significantly higher when using an interest rate differential. Variable rates can also be converted into fixed rates. That way, when a borrower is happy with the low rate they are receiving, they can convert to a fixed rate. The major downside to the variable interest rate is that when the rates go up, it does not benefit the borrower. For this reason, borrowers need to maintain a strategy when it comes to variable rate mortgages.
How To Play It Smart With A Variable Rate Mortgage?
Given that variable rates are volatile, they can be quite risky. But there is a way to reduce this risk and even pay off the mortgage quickly, and that’s by treating the mortgage as a fixed rate mortgage. Borrowers can use the interest savings from these mortgages to make prepayments, or the money saved can be utilized when the variable interest rate increases. These steps should help offset the costs caused by rate spikes.
Let’s consider a situation where the total mortgage acquired is $500,000 with an amortization of twenty-five years and monthly payments. The borrower takes on the mortgage for a five-year term. Now, assume the variable rate is 1.5%. Given this rate, the total monthly payment will amount to $2,000. With a higher fixed rate, say 2.5%, the monthly payments will be approximately $2,240. That’s $240 extra! This amount can be saved up every month to counter the risks posed by variable rate mortgages or to pay off the mortgage sooner!
What Are Hybrid Mortgages?
Based on the points discussed so far, it’s pretty clear that variable mortgages are a great option and can definitely help borrowers save money in the long run. But sadly, 66% of Canadians tend to lock into fixed rate mortgages. For borrowers looking for the security provided by fixed mortgages but the flexibility of variable rate mortgages, opting for a hybrid mortgage is a smart decision.
A hybrid mortgage allows borrowers to have both variable and fixed rate benefits. The mortgage is also called a combination mortgage as it combines a fixed rate portion with a variable rate portion to make up the ultimate mortgage. The fixed and variable portions do not have to be fifty-fifty. Some mortgage providers allow a 30% variable interest rate for a five-year mortgage term and a 70% fixed interest rate for a three-year mortgage term.
Variable Mortgage With Fixed Mortgage Payments
Many banks provide variable mortgage payments that are fixed, even when the variable rate changes. Borrowers that want certainty when it comes to their monthly payments can opt for fixed variable mortgage payments. This means that their day-to-day budget won’t be affected when interest rates increase. What will happen with their mortgage payment is a larger portion will go towards covering the cost of interest instead of the principal amount. Should the variable rate decrease, the borrower will be utilizing more of their monthly payment to pay off the mortgage faster.
But, even though fixed variable mortgages allow for budgeting certainty, they do not guarantee that the monthly payments will remain fixed. Should the variable interest account for more than the monthly payment, the money paid towards covering the interest cost will have to increase. Additionally, after the variable mortgage term is over, borrowers must accelerate their amortization by increasing the size of their mortgage payments for their subsequent mortgage term to cover the principal that they did not repay as scheduled.
Variable Mortgage With Variable Mortgage Payments
Under this mortgage, borrowers have to make payments that will fluctuate based on the variable interest rate. Variable mortgages with variable mortgage payments are also known as adjustable rate mortgages (ARM). As these mortgage payments change with the interest rate fluctuations, mortgage amortization doesn’t change even if the rate changes. This allows for on-schedule mortgage repayment. However, as the monthly payment will be different from time to time, budgeting can become a challenge, especially when the rate increases.
On account of the challenge that the variable mortgage with variable mortgage payments causes, there are very few banks that offer it. Scotiabank is one of the few that do in Canada. The Scotia Flex Value mortgage has a mortgage payment that fluctuates every time the mortgage rate changes. If borrowers don’t want inconsistent mortgage payments, then the Scotia Ultimate Variable Rate mortgage allows them to have a fixed mortgage payment. Scotiabank only offers fixed mortgage payments for variable mortgages with a three-year term. Scotiabank’s five-year variable mortgage has a variable mortgage payment.
Adjustable-rate mortgages are more common among B-lenders and smaller mortgage lenders. Some lenders, such as CMLS, also allow borrowers to convert their adjustable-rate mortgage to a fixed-rate mortgage.
When Should One Opt For A Variable Mortgage?
Based on market trends, variable mortgages can save more money compared to fixed mortgages. This has been the case in the last few decades, and it still holds true today. If a borrower can handle uncertainty and is willing to put up with the possible risks, then a variable mortgage is a suitable option for them. Those who are afraid of possible uncertainty can settle for a fixed mortgage. Either way, the choice is up to the borrower.
If you need help determining if a fixed or variable mortgage is the right option for you, reach out to Boychuk Mortgage Group. We know how to simplify your mortgage journey and offer you a stress-free process from start to finish. Given our expertise and experience in the industry, we offer our clients all of the information needed to make an educated decision that best suits their financial needs. We serve clients across Lower Mainland, and The Greater Vancouver Area including Vancouver, North Vancouver, West Vancouver, Richmond, Burnaby, New Westminster, Coquitlam, Surrey, Delta, Langley, Abbotsford, Chilliwack, Squamish, Maple Ridge, Kelowna, and Mission. Also serving across Victoria, Nanaimo, Campbell River, Port Alberni, Courtenay, Langford, Oak Bay, Saanich, Vancouver Island Area, Kelowna, Penticton, Kamloops, Osoyoos, Summerland, Peachland, Oliver, Okanagan Region, Cranbrook, Salmon Arm, Nelson, Castlegar, Trail, Kootenay Region, Revelstoke, British Columbia and the surrounding areas.