Lets dig a little deeper to understand variable rate and fixed rate so that you can decide which is best for you. Note, these mortgages referred to in this post are closed mortgages, which is what most Canadians have their mortgage in as the interest rates are the lowest.
First understand that a mortgage payment, whether monthly, biweekly or weekly will consist of an interest and a principle component. The principle being the loan amount, and the interest being added. This is called a blended payment or (P & I).
At the time we are putting a mortgage in place, a variable rate mortgage will typically have a lower interest rate than the fixed rate offerings. This is because a variable interest rate can fluctuate with the rising and falling of borrowing interest rates of over the course of your term . With a fixed interest rate mortgage lenders will need to account for potential rising interest rates so they set the interest on a fixed rate higher to provide a buffer.
A Variable (or Adjustable) Interest Rate Mortgage
A variable interest rate (also referred to as an adjustable rate) will have a interest percentage (+ or -) (the variant) off the banks floating rate known as prime. For example Prime Rate minus a certain percentage. The discount portion you are approved for, will remain the same throughout your term, but it is prime rate that may change as it is influenced by the Bank of Canada’s (BoC) policy interest rate.
Today when writing this, Prime with most banks is 3.70%, if your variant is -1.00% then you are paying 2.70% if prime increase to 4.70% then with your -1% discount you will pay 3.70%. If it drops down again to 4.45%, then you your interest payment paid is set now to 3.45%. As the interest rate fluctuates, so will your mortgage payment.
Example:
Mortgage: $400,000
Amortization: 25 years
Term: 5 years
Interest rate: Prime -1.00%.
Prime at 3.70%- so payment is based on 2.70%
Mortgage payment= $1831.95
If Prime rate drops to 3.45%, your interest rate is now 2.45%. Your payment will be adjusted with the interest rate, but will still be based on the original mortgage amount ($400,000) and the original amortization at the start of your term (25 years)
Mortgage payment= $1781.92.
If Prime increases to 4.45%, your interest adjusts to 3.45% and your payment does too
Mortgage payment =$1986.54
If you don’t like the idea of your payment going up, there are some variable rates that have a cap, where unless the interest increases to the point your payment is not covering the interest portion of your blended P and I payment it will not change, this means as interest rates rise, more of your payment is going towards interest and less toward your principle or vice versa when interest rates drop. There are also other ways to create more stability we can discuss such as setting you payment higher at the fixed rate you would have paid. IF you have a variable rate mortgage and worry about rising prime rate, most lenders will allow you to convert to their current fixed rate, without any penalties.
The policy interest rate that influences the Banks prime rate does not change daily. The bank of Canada meets at 8 prescheduled meetings throughout the year and look at the struggles or speed of growth in the economy and use the policy interest rate to help control inflation. There have been periods where prime remained the same for 24 or more months, and there have been times where it has changed 2-3x in one year. Typically when the bank makes changes to the policy interest rate, they will adjust it by 0.25%. However recent times have seen the bank increasing as much as 0.50% while trying to reduce inflation. This demonstrates that even though economists look to historical trends to make shorter term predictions to interest rates, no one can forecast how much and how often prime will change. Its simply impossible to know because it ebbs and flows with changes in the market. Things like inflation, economic uncertainty, wars, pandemics, supply and demand issues are all considered.
Check out Understanding our policy interest rate – Bank of Canada to have a better understanding of what’s known as overnight lending rate.
Fixed Interest Rate Mortgages
Fixed rate mortgages offer you stability and consistency in payment amount because your payments will not change for the entire length of your mortgage term, and they are an equal amount every month. Fluctuations in prime rate will not affect you, as your payment is FIXED for the duration of your term. With fixed rate mortgages you can choose from Terms from 6 months to 10 years, with the most common being the 5 year fixed. A note about the 5 year fixed, while gives you a number of years knowing that your payment does change, it will come with the highest penalty to break, especially if your mortgage is placed with a major bank.
Example:
Mortgage: $400,000
Amortization: 25 years
Term: 5 years
Interest rate: 5.04%
Mortgage payment= $2335.54
This payment will not change for the length of your mortgage term.
Penalties to Break Your Variable or Fixed Rate Mortgage
Closed mortgages will have the best interest rates compared to an open mortgage that can be paid off any time without penalty. In any closed mortgage term, if you break your mortgage, you will incur a penalty.
With a fixed rate mortgage, your penalty will be the higher of either 3 months worth of interest payments OR the difference between your interest rate and the current interest rate closest to what is left in your term multiplied by your remaining balance and may consider the original discount you received; typically with major banks. The latter is is called an Interest rate differential or IRD penalty.
A variable rate mortgage will only ever be a 3% interest penalty as IRD penalty is not considered with a variable rate mortgage.
While a 3 months interest penalty is simple to calculate and typically works outs to less than 1% of your mortgage balance an IRD penalty is typically 3-5%, greatly depending on where you are in your term, what current interest rates are, and in the way your mortgage lender calculates their IRD.
* there are “low rate” mortgage products that have further fine print with penalty calculations and restrictions, this blog is not considering restricted mortgage types.
When you are looking at your mortgage options, work with us at Mortgage Sisters West! We will help you weigh the pro’s and con’s in the market that you are buying in, as to what mortgage type may be best for you and your unique needs.
We serve all of Alberta, with a focus on our local Edmonton, Sherwood Park, St. Albert, Fort Saskatchewan, Spruce Grove, Stony Plain, Beaumont, Leduc and surrounding areas!
We are franchised with our National Brokerage Mortgage Architects and can broker your mortgage in other provinces as well. We would love to work with you!
