Two words pop up in mortgage conversations a lot: Variable and Fixed. I’m usually asked, Stevie, how do i know the best choice between a fixed mortgage and a variable mortgage? My reply usually begins with: “Well, it depends…” But before delving into the juicy stuff, let’s establish some clarity on what the two terms actually mean.
What is a Fixed Rate Mortgage exactly?
Because the interest rate remains fixed throughout the term, you can know in advance the amount of interest you’ll have to pay throughout the term. It’s also easy to determine what portion of the loan will be paid off by the time your mortgage comes up for renewal.
And What About a Variable Rate Mortgage?
Think in reverse terms here. If you choose a variable interest rate mortgage, the interest rate can change during the term of the loan. Why? In Canada, variable interest rate is determined by the prime rate set by the Bank of Canada.
As the prime rate goes up or down, so too does the interest rate on your variable mortgage. As a result, it’s simply impossible to know in advance how much of your original loan will be paid off during your mortgage term.
A Quick Heads-up: Your mortgage broker ought to provide you with an estimate based on the variable rate you started with at the beginning of your term.
How to Feel Secure in an Insecure World?
Some lenders offer what’s called an “interest rate cap” and a “convertibility feature” on the mortgages offered. These two options can provide some degree of protection if indeed interest rates head north. Remember though, these features are available only when you sign a new mortgage agreement.
An interest rate cap is the maximum interest rate that can be charged on your mortgage, regardless of the rise in interest rates.
What about the convertibility feature? With this option, you can “convert” or change your variable interest rate mortgage to a fixed interest rate mortgage during the term. Usually, lenders won’t charge a penalty for the conversion, but some conditions usually apply—so be sure to get clarity from your mortgage broker.
On to the Million Dollar Question. “How do I decide which is a better option for me?”
Without getting into the variety of technical theories floating out there, see if you fit into any of the following statements:
Going the Fixed Interest Rate Direction:
- I value predictability and shun risks.
- I will most likely not be selling my home during my mortgage term.
- I want to know that my interest rate or the amount of my regular payments is not going to change over the term of my mortgage.
- I prefer knowing in advance how much of my mortgage will be paid off at the end of the term
- I think there is a good chance that market interest rates will rise over the term of my mortgage.
Going the Variable Interest Rate Direction:
- I follow market interest rates fairly closely.
- I can handle an increase in my mortgage payment if interest rates go up
- I could pay more in interest over the term of my mortgage than I would have paid with a fixed interest rate
- I think there is a good chance that rates will stay the same or even drop over the term of my mortgage.
These are the basics folks. Yes, there are certainly other dimensions to the debate that we could delve further into. Stay tuned for my next Mortgage 101 post where I discuss what you need to know about an Opened versus Closed mortgage! What about you, got questions?