So you’re getting a mortgage, but which one is right for you? Your first important choice will be between a fixed-rate mortgage or variable-rate mortgage. Unlike some decisions — such as floorboards versus deep pile carpet — there’s no universally correct answer. To decide which suits you, there are several factors to consider.
Here’s what you need to know to make the right choice.
What are fixed-rate mortgages?
Fixed-rate mortgages are what they say on the box — your rate and monthly payments remain the same throughout your mortgage term. Once your term is up, you’ll need to renew with a new rate, term and possibly even a new lender.
Mortgage terms typically last from one to 10 years, with the most popular being five years. That’s why most mortgage rates in Canada are advertised for five-year terms. Your mortgage term is different from the amortization period, which is the total amount of time you have to pay off of your entire mortgage, generally
25 to 30 years.
With fixed-rate mortgages, your payments will be steady for your entire term. Using Ratehub.ca’s mortgage calculator, here’s what your monthly payments would be like if you got a five-year fixed mortgage rate for a $600,000 home, with a 20-per-cent down payment and a 25-year amortization period.
Fixed rate pros:
- Your mortgage rate won’t change throughout your term
- Consistent payments make budgeting easier
Fixed rate cons:
- If the prime rate drops, you miss out on possible savings because your mortgage rate and payments remain the same
- Historically, fixed rates are more expensive than variable rates
What are variable-rate mortgages?
With variable-rate mortgages, your rate fluctuates with the market because it’s tied to your lender’s prime rate. The prime rate is the “standard” lending rate set for loans by your lender. Variable rates are expressed as prime plus or minus some percentage, such as prime -1 per cent. Even if the prime rate changes during the term of your mortgage, your rate’s relationship to prime will stay constant.
For most people with variable-rate mortgages, their monthly payments change whenever the prime rate changes. When the prime rate goes up, their effective mortgage rate also goes up, and so do their monthly payments. When the prime rate goes down, their monthly payments also go down.
As an example, let’s compare the cost of a five-year variable-rate mortgage, versus a 3 per cent fixed-rate mortgage. In this example, we’ll use a $600,000 home, a 20-per-cent down payment and a 25-year amortization period
In some cases, there are lenders who hold the monthly payment for variable-rate mortgages the same throughout the term. Mortgage payments have two components: the interest and the principal — the principal is the actual amount you borrowed. To hold the monthly payment the same, lenders adjust the allocation between the principal and the interest.
For example, let’s say you had a variable-rate mortgage with a monthly payment of $2,000: $1,000 towards interest and $1,000 paying down the principal. If rates drop, you’ll still pay $2,000 overall, but the interest portion will decrease, to $800 for example. The additional $200 will be shifted towards your principal and help pay off your mortgage sooner.
On the other hand, if rates increase, the principal portion of your payment will be reduced and more of your payments will be lost to interest. This can extend the life of your mortgage, because you’re paying the principal off slower, thereby costing you more over time.
Variable rate pros:
- If prime rates drop, your mortgage rate drops
- Historically, you can save more over time with a variable rate
Variable rate cons:
- Financial uncertainty — if rates increase, your payments increase
Watch: Here are three trends you can expect from Canada’s housing market in 2020. Story continues below.
Which is better?
It really depends on your financial situation, comfort with risk and current market conditions. Fixed-rate mortgages are significantly more popular, but that doesn’t mean they’re right for you. Here are some things to consider:
Appetite for risk: Fixed rates are generally safer. By guaranteeing your rate, your lender takes on the risk of rate increases. Variable rates can save or cost you money, depending on how the prime rate changes. If you’re comfortable with more risk, or think you know where rates are headed, variable rates could be a good option.
Market conditions: Rate changes can have a major impact on payments. A typical $600,000 mortgage with a 2.5 per cent variable rate requires monthly payments of $2,150. At 3 per cent, monthly payments rise to $2,272. If rates climb to 5 per cent, payments jump to $2,792, If you choose a variable rate, make sure there’s room in your budget for increased payments.
Mortgage term: Things might change over the life of your mortgage. While high interest rates seem unlikely today, that could change within 25 years. Also consider changes in your own life. Having a child, getting married or taking on debt will seriously impact your finances. If big changes are on the horizon, fixed rates can provide stability during the term of your mortgage.
The bottom line
Financially speaking, the differences between variable- and fixed-rate mortgages are relatively minor, barring unforeseen market shakeups. If you’re worried about increasing rates, it’s hard to go wrong with fixed rates. In the rare occasions when fixed rates are actually lower than variable rates, then it’s definitely the way to go. Just make sure you shop around for the best deal, and always negotiate when you renew your mortgage — but that’s a story for another time!
At Ratehub.ca we make it easier for Canadians to choose better personal finance. With the best tools, rates and knowledge to help you take control of your money. Whether it’s a mortgage rate or insurance rate, a credit card, chequing account or high-interest savings account, we are your champions of choice.