Buying a new home is exciting. However, the process can also be complicated. One of the first steps in figuring out your mortgage options is determining whether to have a fixed-rate or variable-rate mortgage. So, before you start deciding between a fixed- or variable-rate mortgage, it’s important to understand the basics of how they work.
When deciding on a mortgage, there are two main factors to consider: whether your goal is flexibility or predictable payment. For those with consistent salaries and relatively low-risk tolerance, fixed-rate mortgages may be the best option. Variable-rate mortgages are better suited for those who have fluctuating incomes and are comfortable having variable monthly payments.
What Is A Fixed-Rate Mortgage?
Fixed-rate mortgages have a monthly payment that remains the same over the life of the loan. The interest rate on fixed-rate mortgages remains locked in for the duration of the fixed term.
The most common fixed-rate terms in Canada are 1, 3, 5, and 10-year mortgage terms. Each month, your payments go towards both principal and interest payments. However, each month you’re paying off more interest rather than reducing the principal balance on your mortgage.
The longer you pay down the loan, the more of your monthly payment will go to the principal. As you continue to pay off this debt, less and less of your payment goes towards interest.
What Is a Variable-Rate Mortgage?
Variable mortgage rates are typically tied with prime lending rates, and can change during the life of a loan. Lenders will calculate variable mortgages using their own prime rate based on the Bank Of Canada prime rate. A variable mortgage rate is a loan interest that fluctuates with the prime rate, which goes up or down depending on economic conditions.
When you first open your mortgage for 10 years at prime -0.5% and then the prime rate decreases to say prime +0.2%, after ten years you may have paid half of your principal balance while only paying two-thirds of what you originally were going towards principal when it was still at the original price of prime -0.5%.
One of the most important features of a variable-rate mortgage is the initial adjustment cap, which allocates an upper limit to how much the rate can be adjusted up during that first adjustment period.
Benefits of a Fixed-Rate Mortgage
Fixed-rate mortgages have a number of benefits. The most notable is that fixed rate mortgages protect you from unforeseen changes in the economy. Any change in interest rates will not affect your monthly payment.
They are an excellent option for budgeters with minimal financial flexibility because they allow them to pay the same amount each month regardless of any fluctuations in rates or the economic status quo. Finally, fixed interest rates provide peace of mind by limiting your risk in the event that interest rates suddenly go up.
Drawbacks of Fixed-Rate Mortgages
Fixed-rate mortgages have some drawbacks worth considering. They carry higher rates than variable ones, and if interest rates go down, you’ll need to refinance or renew your mortgage to take advantage of the rate drop. Another potential tradeoff of a fixed rate mortgage is the increased monthly cost that comes with higher interest rates.
When borrowers can’t afford the monthly payments, they may opt for a longer repayment period. This results in more interest paid over time.
Benefits of a Variable-Rate Mortgage
Going with a variable-interest rate mortgage can come with its own rewards. Variable rates are usually lower than fixed rates, and if the interest rate does not increase much over time, you can save more on payments than with fixed-rate mortgages.
When prime rates drop, ARMs (variable rate mortgages) work in your favor and you can pay back the mortgage more quickly. The initial lower monthly payments that come with variable-rate loans can be an incentive to use these type of loans instead of fixed-rate ones because they give the opportunity for qualifying for a larger loan.
Drawbacks Of Variable Rate Mortgages
There are a few disadvantages associated with variable rates mortgages. One of the most notable drawbacks is that your interest rate will increase if the prime rate rises dramatically, which would have a great impact on monthly payments and possible defaulting on your loan.
If the interest rates on your variable mortgage rate rise, you will pay less of your loan’s principal balance. While variable rate mortgages start out costing less, they may gradually increase by the time you finish paying for them.
Which Type Of Mortgage Should You Choose -
Fixed Or Variable Rates?
The benefits and drawbacks of fixed rate or variable rate mortgages should be taken into account when deciding which type will best suit your needs. When choosing between fixed and variable rates, consider these main factors: how low the current rates are and how likely they’re going to fall in the future.
A fixed-rate mortgage is perfect for people who have a strict budget and do not want to deal with the risk of interest changes. Variable rate mortgages are great for borrowers who prefer to take advantage of lower interest rates when they decrease, and can afford monthly payments if interest rates increase.
Keep in mind that you must have a high and stable enough income to afford any drastic rate changes brought on by variable rate mortgages or risk defaulting. If you believe interest rates will fall during your loan term, then a variable rate may be best. If you predict that interest rates will rise over time and don’t want to be subject to rate changes, a fixed-rate mortgage is best.
Bottom Line
With so many considerations, choosing a mortgage can be an overwhelming task. When deciding between a fixed rate mortgage and variable rate mortgage, consider your financial habits as well as your long-term goals. If you have a set budget and are not comfortable with variable interest rates, fixed-rate mortgages offer security.
If you prefer a lower initial mortgage rate and are financially comfortable in case the rates rise, variable-rate mortgages could be the right option for you. The best way to secure a loan is by shopping around and comparing rates.
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