Should You Choose A Variable Rate Mortgage Or A Fixed Rate Mortgage?
Since the start of the pandemic, rates for fixed-term mortgages in Canada have not increased much until the start of 2021. In fact, fixed rates have grown by an average of 100 basis points (1.00%) since January of 2021. Fortunately, even while rates on fixed-term mortgages keep increasing, rates on variable mortgages remain steady at record lows.
Given the current situation, it may be a good idea for homebuyers to consider a variable-rate mortgage. It is important to note that just because variable rates are considerably lower than fixed rates these days, a variable rate mortgage may not be the right choice for everyone.
While these two types of mortgages are different, it is imperative to be informed of the advantages and disadvantages of each. To bring you up to date on the basic pros and cons of these options, Mortgages with Gary wants to help you understand how fixed-rate and variable-rate mortgages work before you make your decision.
Why are fixed rates going up and variable rates holding?
Fixed-rate mortgages often adhere to Canadian bond yields, which are closely tied to bond yields in the US. When optimism in the economy improves, investors take money out of safer investments like bonds and into riskier investments like stocks. As the demand for bonds slumps, bond prices drop, and yields increase. As a result, both the Canadian and US bond yields have been growing steadily over the past few months and fixed mortgage rates have been increasing.
On the other hand, variable mortgage rates mirror the Bank of Canada’s overnight lending rate, which is the rate that lenders use to supply overnight loans to each other. When this overnight interest rate changes, changes in the prime rate follow. The prime rate is what the banks use as a guide to pricing their variable-rate mortgages.
Under weak economic conditions, the Bank of Canada may drop its overnight lending rate. In fact, the central bank has already confirmed it has no intention of raising the rate until the middle quarters of 2022 to support economic recovery after the pandemic. On January 26, 2022, the bank held the overnight rate at the record low of 0.25%. Low rates are likely to continue given the persisting instability of the COVID-19 crisis. This is good news for homebuyers taking out variable mortgages.
What are the risks of a variable rate mortgage?
Variable-rate mortgages may fluctuate alongside changes in the prime rate, unlike fixed-rate mortgages, which remain the same for a pre-set number of years.
Variable-rate mortgages tend to have the lowest prepayment penalties, typically being only three months of interest payments, whereas, fixed-rate mortgages will charge a prepayment penalty of interest-rate differential or three months of interest payments, depending on which is greater.
The interest differential is calculated based on the difference between how much interest rates have fallen since you originally took out the mortgage multiplied by the time remaining on your current mortgage term. This can result in thousands and even tens of thousands of dollars in prepayment penalties that the homeowner would have to pay to break their mortgage.
Why are variable rates less popular?
Fixed-rate mortgages assure borrowers that their rate and amortization will remain the same for a predetermined time. Variable mortgages come with the risk that when economic conditions improve, the rate may increase.
For a long time, variable rates hovered in and around the same range as fixed rates. As a result, homebuyers had the tendency to “play it safe.” However, statistically, about 80% of variable-rate mortgages saved borrowers money in the long run compared to their fixed-rate counterparts.
As an expert, I recommend that all homebuyers, especially first-timers, get help from a mortgage broker who can walk you through all of the short-term and potential long-term costs that come with homeownership and a mortgage.
First-time homebuyers are more likely to break a mortgage after the first few years to upgrade to a larger home. As a result, we see many first-time homebuyers incur penalties after only having their home for two or three years because they were not properly advised by their previous mortgage professional. If you are purchasing your first home, you may decide to opt for a shorter-term (two years or three years) fixed-rate mortgage rather than a five-year solution.
If you plan on getting a variable rate mortgage, then in most cases, a five-year term is the right choice as you will be getting a lower rate than with a two-year or three-year term, and the breaking penalty will likely be very low at any given point in time.
For more information on variable-rate mortgages or fixed-rate mortgages, reach out to me at Mortgages with Gary. I can help you decide whether it is the right time to invest in a variable-rate mortgage. My experience, knowledge, and access to more than fifty lenders will help you find the best option for you. I will advise you on whether a variable-rate mortgage or fixed-rate mortgage is better for you based on your current needs and long-term goals.