Fixed Rate vs Variable Rate Mortgages: A Closer Look
Although, both rates have its own pros and cons, they both are highly dependent on the borrower circumstance. But before we want to identify which one is better for each given situation, we need to define the characteristic of each rate and what their differences are.
To get there, first we need to introduce two terminology:
- Over night lending rate: according to the Bank of Canada, “the overnight rate is the interest rate at which major financial institutions borrow and lend one-day (or "overnight") funds among themselves” (to balance their books). Governments leverage this rate as part of their monetary policy to control the market.
- Charter Banks PRIM rate: Prime rate is the interest that the major commercial banks determine to charge on their lending products such as loans, credit cards, mortgages, etc. Prime rate is highly depending on the over night lending rate.
Fix and Variable rate:
Variable rate is a type of rate that is link to the Prime rate and as a result might have fluctuation during the term of mortgage. As a result of this fluctuation, the mortgage payment might increase accordingly (Adjustable rates). In most cases your monthly payment remains the same and only the interest portion of the payment will change proportionally which will increase your amortization. The payment will increase only if the interest portion of the payment exceed the total payment. Meaning, your total monthly payment does not even cover the interest portion.
If we consider the likability of the payment fluctuation as the down falls of variable rate, the upside is that historically the borrower pays less interest for the term of the mortgage. Also, in case the borrower needs to exercise the pre-payment option and pay back the loan before the end of the term the penalty calculation is only 3 months interest.
On the other hand, If you choose fix interest rate the payment remains fix throughout the term regardless the market performance. The security and peace of mind is the best character of the fix rate where the borrower knows that the payment would not change no matter what. So, it gives the borrower a better position for planning purposes. However, the penalty calculation for such rate are different and potentially are higher than variable rate. At the time of breaking the mortgage, if the current market rate in the market is lower than your mortgage rate, you have to pay the penalty that is equal to total amount of the loss for the remaining term to the bank (so called Interest Rate Differential or IRD). Meaning that the bank calculates the difference between your rate and the current market rate over the remaining term of the mortgage. That being said, if the interest rate in the market has gone up, the borrower will only pay the 3 months interest similar to the variable rate.
As, you have noticed, choosing between these two terms seems challenging and wrong decision might result in a costly consequence. Seeking a right advise from a professional mortgage specialist would be highly recommended.