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Understanding Fixed vs. Variable Rate Mortgages
January 22, 2025 | Posted by: Christopher Chanakos
Fixed vs. Variable Mortgage Rate: Which One Works for You?
When deciding between a fixed-rate or variable-rate mortgage, understanding their differences is key. Each option has distinct advantages and risks, catering to different financial goals and tolerance for uncertainty. Moreover, homebuyers need to be aware of the difference between variable rate mortgages and adjustable rate mortgages.
Fixed-Rate Mortgage Overview
Types of Fixed-Rate Mortgages:
- Closed Mortgage: The most common option, with limited opportunities for early repayment. Breaking the contract before the term ends can incur high penalties.
- Open Mortgage: Offers the flexibility to repay the mortgage in full at any time without penalties. This flexibility often comes with higher interest rates.
Benefits of Fixed-Rate Mortgages:
- Stability: Your interest rate and monthly payments remain consistent throughout the term, offering peace of mind.
- Predictability: From the outset, you know how much of each payment goes toward principal and interest, as well as the timeline for paying off the mortgage.
Risks of Fixed-Rate Mortgages:
- Higher Initial Rates: Fixed rates can be higher than variable rates initially.
- Lack of Flexibility: If rates drop, your rate remains unchanged unless you refinance, which may involve fees.
- Substantial Penalties: Breaking a closed, fixed-rate mortgage can result in significant prepayment penalties if you sell or refinance.
- One caveat to the IRD penalty: If your contract rate is lower than the current rate, your penalty will likely be three months interest.
How Fixed-Rate Mortgages Work:
Fixed-rate mortgages are the most popular type in Canada, providing stability by locking in your interest rate for a specific term, whether it’s six months, five years, or longer. During this time, your rate and payments are unaffected by market changes. Typically, longer terms come with slightly lower rates, offering added predictability.
Variable-Rate Mortgage Overview
Types of Variable-Rate Mortgages:
- Variable-Rate Mortgages (VRM): Your monthly payment remains constant. If rates decrease, more of your payment goes toward the principal; if rates rise, more goes toward interest. Significant rate increases could trigger adjustments to cover rising interest costs.
- Adjustable-Rate Mortgages (ARM): Payments fluctuate directly with rate changes, offering less predictability but aligning costs with market conditions.
Benefits of Variable-Rate Mortgages:
- Potential Cost Savings: When rates remain steady or decline, you’ll likely pay less interest compared to a fixed-rate mortgage.
- Lower Break Penalties: Breaking a variable-rate mortgage typically incurs penalties equivalent to three months’ interest.
- Option to Switch: Many lenders allow borrowers to convert to a fixed-rate mortgage at any time.
Risks of Variable-Rate Mortgages:
- Uncertainty: If rates rise, your payments could increase, potentially costing more than a fixed-rate mortgage.
- Conversion Costs: Switching to a fixed-rate mortgage means adopting current rates, which might be higher than the initial fixed-rate option.
How Variable-Rate Mortgages Work:
Variable-rate mortgages are tied to prime rates, meaning your interest rate can fluctuate based on economic conditions. This option is ideal if you anticipate stable or declining rates during your term, but it carries risks if rates rise significantly.
Which is Better: Fixed- or Variable-Rate Mortgage?
If stability and predictability are important to you, a fixed-rate mortgage may be worth the additional cost and potential prepayment penalties. If you’re comfortable with some uncertainty and want to take advantage of potential rate decreases, a variable-rate mortgage could save you money. Moreover, if you think there is a chance that you will break your mortgage contract, variable would be the way to go.
Whether you choose a fixed-rate or variable-rate mortgage, aligning the choice with your financial goals and risk tolerance will help ensure a decision that suits your needs. Working with a mortgage broker will ensure that your goals align with these considerations.