May 14, 2016
The great debate. Fixed vs variable rate mortgages
Banks make a lot of money off mortgages. But consumers are getting savvier. They’re not just going to their local bank branch. Now they’re shopping around for the best rate, or going through a mortgage broker. This makes sense. Comparison shopping can save a borrower thousands in the long run.
Deciding if you should go variable or fixed can be a tough decision to make. Both options have their advantages and drawbacks. Let’s run through them.
The difference between variable and fixed-rate mortgages
Fixed Rate: This mortgage is usually set over a term of 1, 4, 5, or 10 years. During that term, the rate you first sign with will be the rate you pay throughout the term of the mortgage. In other words, there are no surprises. You have a permanent rate and payment that won’t change. This is great for peace of mind, especially when the future holds uncertainty.
The fixed rate is higher than the variable rate, with very few exceptions. Taking a fixed rate over a variable is almost like taking an insurance policy. It’s predictable, so you are taking on much less risk. That is why fixed rates are priced higher.
The fixed rate itself is driven by Canada Bond yields, which are driven by economic factors such as unemployment or inflation. Lately, these 5-year bond yields have flattened. They pay less than 1% interest following decades of declines. These declines drove fixed mortgage rates to some of the lowest rates ever.
Mortgage Professionals Canada expects fixed rates to start slowly increasing along with these bond rates. This might be a sign that fixed rates have bottomed out. The current prices on them are as low as they’ll go.
Variable Rate: Like the fixed rate, these are also set on a 1, 3, 5 or 10-year period. However, they are priced at a lower rate than the fixed rate mortgages. Why? Because if you go this route, you take on more risk.
Unlike fixed rates, variable rates might change over the term of your mortgage. They can increase or decrease. Economic factors also drive these rates. Your rate isn’t secured. Variable rate mortgages are driven by the Prime Rate. Generally, the Bank of Canada will reduce rates when the economy needs some stimulus. It will raise them when the economy is doing well, to control inflation.
We don’t have a mortgage rate crystal ball and can’t know if variable rates will increase, decrease, or stay the same. As such, you have to be prepared to take on some risk. Your rate may increase. If that happens, will you still be able to afford to pay it off every month? For one-third of Canadian families, an increase of as little as 1% could mean they will default on their mortgages.
While no one knows what the Bank of Canada will do with their rates, experts say it seems likely rates will remain relatively stable or increase. In addition to that, the government has warned banks that dropping their rates any lower might spark a housing crisis.
Comparing fixed and variable-rate mortgage. Which is better?
It’s possible to save money on a variable rate mortgage (assuming no major rate increases). However, the difference between fixed and variable rates is not significant right now.
Consider a hypothetical mortgage of a $500,000 home on a 5-year term. The buyer has 20% down (amortized over 20 years). Here is a comparison with rates as of Spring 20161
Which mortgage is better? It depends
As you can see, the savings difference on a monthly basis by going variable isn’t too significant at the moment. Variable rates are likely to increase over the 5-year term. Therfore, it might be worth paying the extra $64 a month to have the peace of mind and stability that a fixed rate mortgage offers in this rate environment. This is a growing trend with nearly 66% of Canadians choosing fixed rates right now.
However, this might not apply to everyone. There isn’t a one-size-fits-all solution. You do have to consider other factors, such as shorter terms or the flexibility you need built into your mortgage. For example, let’s say you sign on to a 5-year fixed mortgage. If you decide to sell or refinance in three years, there could be some hefty fees to do that.
What if you go with the variable rate in hopes of saving some money? In that case, perhaps consider opening a high-interest savings account. Put away the difference that you would be saving versus a fixed mortgage. That way, you mitigate some of the risk of rising rates. If rates do go up, you’ll have a cushion to help you pay it off. On the other hand, if rates decrease then you’ll be in a better position.
Watch out for low-interest lenders who require CMHC insurance with 20% down. Some lenders would like to minimize the risk of default and they will require the CMHC insurance regardless of the size of the downpayment. The CMHC premium is a one-time percentage of a mortgage balance, so treat it as ‘hidden’ extra interest. Make sure you are comparing apples-to-apples when comparing interest rates as the advertised rate is only half the story.
A fixed rate looks really attractive at the moment and might be the way to go for many. But if you’re unsure of how to navigate all these possibilities and details, be sure to talk to a reputable professional about what might be best for you based on your situation.
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