Before talking about which is better, it’s important to first understand the difference between a fixed and a variable rate mortgage.
With a fixed rate mortgage, your rate and payment remain the same for the term of the mortgage. Since the interest rate does not change throughout the term, you know in advance the amount of each payment, and the amount of interest you pay during the term.
With a variable rate mortgage, both the interest rate and payment can change throughout the term of the mortgage. At the start of a variable term, the rate is usually set in relation to the prime rate – for instance prime less 0.35%. As the prime rate changes, the rate will change accordingly. As an example, the current prime rate is 3.0%, so if the mortgage was set at prime less 0.35%, the current rate would be 2.65%. If prime rises to 3.5%, the rate charge on the mortgage would change to 3.15%.
With a variable rate, the payment may remain fixed throughout the term, or it may change (depending on the policy of the lender). If the payment remains fixed and the rate changes, what will then change is the percentage of payment which is applied to principle versus interest.
When you’re in the marketing for a mortgage and trying to decide whether a fixed or a variable rate will be better for you, there are a few things you may want to consider:
– Can you qualify for both a fixed and variable rate mortgage?
With recent changes in mortgage regulations, most mortgages that are either variable rate, or less than a 5-year fixed term, must qualify on the benchmark rate. What this means is, despite the fact you’re getting a rate of 2.65%, you must qualify based on the payments being at the “benchmark” rate (currently 5.14%). If you’re applying for a 5-year fixed rate however, you can qualify at the contract rate (currently around 2.89%). Based on the mortgage size, some clients will only qualify for a 5-year fixed term.
– Are rates likely to rise, fall or stay the same over the term of the mortgage?
In either a falling rate environment or en environment where rates are flat, a variable rate mortgage will typically save you money. In a rising rate environment, fixed rate will typically do better.
– Am you likely to sell my home or refinance mid term?
It’s important to look at your penalties to break your mortgage. With most variable rate mortgages, the penalty is usually set at 3-months interest. With most fixed rates, it’s the greater of 3-months interest of the Interest Rate Differential (IRD). IRD can be quite significant, especially in a falling rate environment. Before signing a fixed rate mortgage contract, it’s important to understand how IRD is calculated, as every lender calculates it different, and some can be quite severe – even in a rising rate environment.
– What is the current spread between the fixed and variable rate?
With a variable rate mortgage, you typically get a better rate (at the start of term), however the trade-off is less stability and the opposite for a fixed rate mortgage. At the time you’re applying, how much of a rate premium do you need to pay for the rate security of a fixed rate mortgage?
– Are you comfortable with fluctuations in rates and payments, or do you want to know exactly what you’re paying every month?
Most people would feel great if their rate and payment were to decrease, but how would you feel if it increased, and now more money had to go toward your mortgage payment?
What are we currently recommending to our clients – based on current market conditions, many clients who are traditionally variable rate clients, are proceeding with fixed rate mortgages, for a few main reasons:
– There is very little (if any) spread between the variable and fixed rate
– In the short term (1 year) rates are anticipated to remain relatively flat. In the mid to long term, it’s anticipated that rates will rise.
As for which is better, a fixed or variable rate – there is no right answer. It’s important to understand the pros and cons of each, so you can make an informed decision that is right for you.