For a long time, it was a common ideology that a variable rate mortgage was ideal when purchasing a home. The thought process was based on the theory that if the rate drops, you’ll be able to reap the benefits of lower interest payments as opposed to someone who is in a fixed-rate mortgage.
Before we get into the nitty-gritty of it, let’s review how interest rates impact a mortgage and the difference between a fixed-rate and a variable-rate mortgage.
Interest rates are determined by the Bank of Canada and often reflect the state of the economy. When the economy is strong, interest rates are high. This means that borrowing money would cost more, but you should receive a higher payout on your investments. When the economy is in a weaker state, the opposite is true: interest rates may drop, reducing the cost of borrowing, but you will receive a smaller payout on the money you have invested. Interest rates regularly fluctuate, which means they can have a significant impact on how quickly you pay off your mortgage.
A fixed-rate mortgage is when your interest rate, and the repayment amount, is locked in place for the length of your contract. You will pay this specific interest rate on your mortgage until it is time for renewal, regardless of how interest rates fluctuate. While you may miss out on some savings should interest rates drop, you’ll enjoy the benefit of knowing exactly what your payments will be with a fixed-rate mortgage.
A variable rate means that the interest you pay on your loan will fluctuate as the national interest rates change. This is based on decisions from the Bank of Canada. A variable interest rate on a mortgage is determined using a discount off the Prime Rate. For example, the prime rate minus 0.50%. This means that if the Prime Rate is 5.0%, your interest rate would be 4.5%, indicating that you would pay less interest than someone who is locked into a fixed-rate mortgage at 5.0%. While a variable rate is frequently lower than a fixed rate, it can float higher, adding a level of uncertainty to your mortgage payments.
Is a Variable Rate Mortgage Really Worth It?
When purchasing your first home, regardless of the market, you want to be able to get the biggest bang for your buck. This is where a variable rate can benefit you. By opting for a variable-rate mortgage, the homebuyer can take advantage of a lower payment and can usually qualify for a higher loan – meaning they can purchase a more expensive home. However, as the market changes and if the interest rate starts to creep up, the cost over time could outweigh the initial benefit of a variable rate mortgage.
The other main factor to consider is the current market rate and expert forecasts. If the market rate is high, opting for a variable interest rate is often more ideal because the market rate will drop in the next five, seven or 10 years, and you will be able to take advantage of it.
There is also a short-term benefit to a variable rate. Should the rates be at a low point and you know you are purchasing a home to flip it in a few years, a variable rate mortgage is more ideal as there is usually a lower penalty for breaking this type of mortgage than a fixed-rate mortgage.
However, if the economy is fragile and interest rates are at an ultra-low point, a variable-rate mortgage may not be ideal. A weak Canadian economy will quickly become less fragile, leading to those with a variable rate mortgage not having the ability to take long-term advantage of the current low interest rates.
With many pros and cons to both sides of the mortgage coin, it’s important to remember to seek professional advice and shop around for the mortgage that best suits your individual needs before locking into a contract.