Fixed vs Variable
Ever wonder what is better, a fixed or variable rate mortgage? There is no right or wrong answer to this question. The fact is, when it comes to mortgages, everyone’s situation is different. What might be best for your situation may be different for someone else’s. It’s important to understand the differences so that you can make the right choice when it comes to YOUR mortgage. In order to decide what the right rate is for you, first you need to know how each type of rate works.
Fixed Rate
Let’s start with a fixed rate mortgage. As you may already know, a fixed rate mortgage means that your rate is fixed and does not change. It remains constant for the entire term of your mortgage, therefore so does your mortgage payment. Your payments will not change until your renewal date unless you make any changes to the mortgage prior to that. Fixed rates are calculated by the lenders and change as prime rate changes. However, these don’t effect your rate once you have a rate hold or are locked in to a contract.
Variable Rate
The alternative to a fixed rate is a variable rate. How a variable mortgage works is by the lender offering a certain discount rate which is subtracted from the prime rate or the lender’s base rate. The resulting amount is your interest payment. To recap: Variable Rate = Prime rate – discount rate. As you can see from the formula, as the prime rate changes so does your interest payment.
For example: if prime rate is 3.2% and your lender is offering a discount of 1% your current rate is as follows. 3.2% (prime) – 1% (discount) = 2.2%
Now if the prime rate changes from 3.2% to 3.7% your current rate changes and is recalculated. 3.7% (new prime) – 1% = 2.7%
Your payments will fluctuate with the changes in prime rate. What does not change is your discount rate. You maintain the same discount throughout the term of the mortgage. If you know your discount rate it is easy to calculate your current mortgage rate even as prime changes.
Variable Rate Mortgage (VRM) and Adjustable Rate Mortgage (ARM)
Variable Rate Mortgage
What you may not know is that there are actually TWO types of variable mortgages. The first is just called a Variable Rate Mortgage or VRM. In a classic VRM your payments do not change. You maintain the same payments throughout the term, but the amount of payment going towards paying the principal balance and paying interest changes.
For example: let’s say your monthly payment is $2000. $1200 is being paid towards the principal mortgage balance and $800 towards interest. If prime rate increases your payment remains $2000, but now only $1100 goes towards the balance and $900 towards interest.
The only time your mortgage payments change is if you reach the TRIGGER rate. The trigger rate is essentially the rate at which point too much of your payment is going towards interest. If the rate has gotten too high where you are no longer paying off enough of the principal balance on your mortgage, then your lender must adjust the payments to make sure you can still meet the amortization schedule. You must still be able to pay your house off by the end of the amortization. The trigger rate is noted in your mortgage agreement and is not the same for everyone. It is important to know what your trigger rate is if you have one.
Adjustable Rate Mortgage
The second variable mortgage is an Adjustable Rate Mortgage or ARM. This is the more common variable mortgage and the one most lenders offer. Unlike a VRM, in an ARM your payments fluctuate more frequently with the change in the prime rate. When prime goes up so do your payments and when it goes down the payments decrease. This ensures that your balance is always being paid off accordingly as rate changes occur. There is no trigger rate with an ARM because your payments are always changing.
Advantages and Disadvantages
Fixed Rates
Fixed rates are great for first time home buyers and people who plan to remain in their home long term. Payments don’t change and this is beneficial for people who would to stick to a monthly budget. If you know exactly what your payments are every month it is simple to budget your expenses appropriately. It also helps create ease of mind knowing you won’t be hit with any unforeseen changes to your payments. First time home buyers are often trying to limit expenses after such a large purchase and this allows them to do so.
With a fixed rate there are high penalties for breaking the mortgage however. If you sell or refinance your property before the mortgage term is up you could pay a hefty penalty. If you are only in year 2 or 3 of a 5-year term when you sell/refinance, you will pay an interest rate differential penalty (IRD). This penalty includes the difference in your current rate and the rate at the time the mortgage is broken. The number of months remaining in the term and the mortgage balance owing are all used to calculate the penalty. This could be a VERY LARGE sum of money you will pay for breaking your mortgage.
Variable Rates
Variable rates are often for people willing to take on fluctuating payments and have the flexibility to do so. With your payments changing it can be hard to budget. If you are already stretching your budget and rates increase it may be difficult to make payments on time.
The positive part of a fluctuating payment is if rates start to decrease then your benefit with a low rate. The rate decrease along with your discount rate can mean you pay very little in interest. This can then lead to more flexibility in your budget and having extra funds for the time being. If you wish to switch to a fixed rate then you have that option as well. You can often switch from your variable rate to a fixed rate any time throughout the term with no penalty. If fixed rates become more favourable or you no longer want the fluctuating payments it is easy to switch.
Additionally, variable rates have a much lower prepayment penalty than fixed rates. If you break your mortgage early in a variable rate you only pay 3 months interest penalty. This gives added flexibility if you plan to refinance in the future or have plans to sell the property. The 3 months interest penalty is significantly lower than paying out the fixed rate IRD penalty.
It is very important to understand the difference between fixed and variable rate mortgages. One rate is not better than the other and it is not a “one rate fits all” situation either. Everyone has a preference and is in a different situation. Speak with a professional and they will help find out what he right solution is for you!