Mortgage Term - FIXED VS VARIABLE RATE

What is a variable rate? 

An adjustable rate mortgage (ARM) or variable rate mortgage (VRM) is a mortgage where the interest rate is subject to change. Most of these products are set up as 5 year terms and use a formula based on the Canadian prime interest rate. (Prime interest plus or minus a percentage)

For example, if you choose an ARM with a rate set at  Prime – 0.50% then your rate would be calculated at any given time using this formula. If prime were 3.00% then the interest rate on your mortgage would be 2.50% or if prime were 6.00% then the interest rate on your mortgage would be 5.50% and so on.

Adjustable rate mortgage products have been very popular lately as prime interest is still near an all-time low and has remained consistently low for the last few years.

What is a fixed mortgage? 

A fixed rate mortgage is just as it sounds.  The rate of interest on your mortgage is fixed at the beginning of your term and is not subject to change.   If, for example, you selected a 5 year term with a fixed rate of 4.25% then all of your payments would be calculated using a rate of 4.25% for the full 5 years of your term.

Things to Consider

Variable rate and fixed rate mortgages both have their advantages and disadvantages.  Historically speaking, homeowners have typically had lower payments with variable mortgages, but these mortgages are also vulnerable to fluctuations in the market.   Variable rate mortgages are tied to the Bank of Canada’s prime rate (which is announced eight times per year) and as such are subject to change.   Fixed rates, on the other hand, are often initially higher than the offered variable rate, but because the rate is consistent throughout the term of the mortgage, they can prove to be lower if the prime rate goes up.

Below are a few questions to help you determine which type of mortgage is right for you:

Can I afford to take a variable mortgage? 

There is some risk associated with a variable rate mortgage, so if you decide to go this route, you must be confident that you can afford the increased payments when the prime interest rate goes up.

One method of protecting yourself involves initially setting your payment to a higher fixed amount.  For example, setting your payments based on the current five year fixed rate will allow you to provide a buffer in the event that rates rise and because you’re paying more than the required minimum amount, you’ll be paying more principal off as well.

Opting for a 25-year amortization but paying the 20-year amortization-sized payment is another way to protect yourself from increasing rates. If rates get too high for comfort, you can gear down to the lower 25-year amortization payment until rates decrease again.

Does variable rate mortgage fit my risk profile? 

Once you have decided you can afford a variable rate mortgage, the next thing to assess is whether a variable rate mortgage fits your personality, lifestyle and comfort zone.  If you’re the type of person that can’t sleep at night knowing that your rate may change by 0.25%, then a variable rate mortgage may not be the best option for you.

What type of variable rate mortgage should I choose? 

There are three main factors to consider when choosing a variable rate mortgage:

Payment Frequency – Make sure you are aware of the options available before deciding.  Some lenders may not allow certain variations of payment frequency (eg. accelerated biweekly or weekly payments).

Rate Changes – Some lenders change their variable rates in line with the Bank of Canada – eight times per year – while others adjust them quarterly.

Conversion To Fixed Rate – Does the lender allow the mortgage to be converted to a fixed rate mortgage at any time without penalty?  If so, what rate are you guaranteed on conversion – the best-discounted rate or the posted rate?