Whether you’re currently renting and are in the market to find your own home, currently live in a home but want something bigger, or want to live in a better neighbourhood, buying a home almost always involves taking out a mortgage from a bank or financial lender. Mortgages are complicated loan agreements that can confuse even industry insiders, so it’s important to understand all of the terms. One of the key decisions you’ll have to make when getting your first mortgage is whether a fixed or variable rate mortgage is right for you.
The Difference Between Fixed and Variable Rate Mortgages
The term “rate” used to describe mortgages refers to the interest rate, the amount you’ll have to pay back the bank or lender on top of the amount that you borrow. Through a combination of market forces, legislation, and policy, banks and other financial institutions offer mortgages at different interest rates. These rates can change, so you’ll also need to know about mortgage rate increases.
A fixed rate mortgage generally refers to a home loan that will be paid back in regular instalments that include an interest rate that will never change. If you take out a fixed rate mortgage at 5% today, then you will continue to pay that 5% interest rate throughout the 10, 20, or 30 years of paying off the loan.
On the other hand, a variable rate mortgage (occasionally referred to as an “adjustable rate mortgage” or ARM) refers to a home loan that includes different rates of interest throughout the repayment period. Many mortgages are offered at an attractive lower rate for the first year (or another period) of repayments but may increase or decrease over time.
In a nutshell, fixed rate mortgages have a higher interest rate but do not involve any risks associated with an increase in interest rates (and therefore your monthly payments) over time. Variable rate mortgages involve calculating whether the lower initial payments will outweigh the possibility of more expensive payments later on during the life of the mortgage.
The Pros and Cons of a Fixed Rate Mortgage
Depending on the type, size, and location of the house and how much money you can put towards it with your initial down payment, it may be easy to get a fixed rate mortgage at an attractive rate. One of the benefits of a fixed rate mortgage is that you’ll always know in advance exactly how much your monthly payments will be and exactly how much interest you’ll (eventually) be paying the bank or financial institution.
By using a convenient online mortgage calculator, it’s fairly simple to take an educated guess as to how much you’ll be paying every month with a fixed rate mortgage. If this amount can be comfortably addressed with your current income level, you can be fairly sure that you’ll be able to make payments on your fixed rate mortgage. For individuals who dislike risks, a fixed rate mortgage adds a lot of budgetary security.
There are, however, some significant downsides to choosing a fixed rate mortgage. Even if interest rates become lower later on, you’ll be locked into the interest rate you chose when you obtained your mortgage. Furthermore, most mortgages in Canada come with what is known as a “pre-payment penalty.” As strange as it may sound to the average person, this system allows banks to charge additional fees to anyone who wants to pay off their mortgage earlier than scheduled. Often, pre-payment penalties include paying the full amount of interest on the loan.
The Pros and Cons of a Variable Rate Mortgage
You don’t have to be a banking expert to realize that choosing a fixed rate mortgage comes with the risk that interest rates may rise in the future. Every mortgage agreement should be carefully read to understand exactly how the interest rate on a variable rate mortgage will affect your monthly payments as well as the total amount you’re obligated to pay back.
Variable rate mortgages leave a lot of borrowers uneasy, but there are several significant upsides. To begin with, most banks and financial lenders offer variable rate mortgages with an initial interest rate 0.5% or lower than the standard prime rate. If that number doesn’t seem too significant to you, remember that just half a percent less money paid towards interest can save you tens of thousands of dollars over the lifetime of the mortgage.
Not only will your monthly payments become lower if interest rates drop, but many savvy homeowners use the difference towards paying back the principal. In other words, if your monthly payments go down by $100 a month, a smart move can be to pay the bank that $100 as an additional payment on the principal of the loan, rather than the interest.
Variable rate mortgages often have either no “pre-payment penalty” or much lower penalties than fixed rate mortgages. If your income increases or you’re otherwise able to pay off your mortgage more quickly in the future, you’ll end up paying the bank a lot less than if you had a fixed rate mortgage.
Only you can decide whether a fixed rate mortgage or a variable mortgage is best suited for you and your needs. There are some risks to choosing a variable rate mortgage but also the potential to save a lot of money in the long run. Fixed rate mortgages offer added stability and security but may end up costing a lot more money over the life of the loan.
Carefully consider all of your options before committing to a mortgage that you may be paying for many years of your life.