Whenever you get a mortgage, one of your first choices is deciding between fixed or variable rates. It’s easily one of the most significant decisions you’ll make since it’ll affect your monthly payments and the total cost of your mortgage over time. While it may be tempting to go with the lowest rate you’re offered, it’s not that simple. Both types of mortgages have their pros and cons, which is why you need to understand how fixed-rate and variable-rate mortgages work before you make your decision.
With fixed-rate mortgages, your interest rate stays the same for the length of your term. It doesn’t matter if interest rates go up or down. The interest rate on your mortgage won’t change, and you’ll pay the same amount every month. Fixed-rate mortgages typically have a higher interest rate compared to variable-rate mortgages because they guarantee a consistent rate.
Although most people go with five-year terms, you can get a fixed-rate mortgage with a term anywhere from six months to 10 years from some lenders. The shorter the term, the better the rate you’ll usually get. Choosing a longer term means you’re essentially buying certainty, but you’ll have to sacrifice lower interest rates to do so.
Variable-rate mortgages are appealing because the interest rates are typically lower than those on fixed-rate mortgages. If interest rates fall during your term, your mortgage interest rate will too — and the amount of interest you pay will decrease.
A variable-rate mortgage typically offers an interest rate tied to the lender’s prime rate, which is usually tied to the Bank of Canada’s prime rate. Let’s say you’ve signed a mortgage for the prime rate -0.50%. Your lender currently has a posted prime rate of 2.50%, so you’ll pay 2% interest. If the prime rate were to fall to 2.25%, your interest rate would be 1.75%. However, if the prime rate went up to 2.75%, your interest rate would increase to 2.25%.
But whether your interest rate goes up or down, you’ll still pay the same amount each time you make a mortgage payment. The difference is in how much is applied to the principal and the interest. When the interest rate goes up, more of each payment goes toward interest; when rates go down, more of each payment goes toward your principal, which will help you pay off your mortgage faster.
Many lenders also allow you to convert a variable-rate mortgage to a fixed-rate mortgage at any time.
Even though fixed-rate mortgages are more popular than variable-rate mortgages, it’s important to consider the pros and cons before making a decision.
Many people are naturally attracted to variable-rate mortgages because the interest rates are lower than for fixed-rate mortgages. That said, rates can change at any time, so you need to look at the pros and cons before choosing your mortgage.
The debate between fixed vs. variable mortgages may seem easy, but many different factors can affect your decision. Traditionally, fixed-rate mortgages have been more popular, but variable-rate mortgages have saved homeowners more money most of the time. That said, with such low interest rates available in recent years, many people are flocking towards fixed rates.
Here are some things to think about before making your decision:
While many people look strictly at the numbers when debating fixed vs. variable mortgages, it’s not that simple. Interest rates can change at any time, so it’s really a coin toss when it comes to which one will save you more money. You might be better off looking at your risk tolerance and thinking about how you’ll feel about changing interest rates.
If you want the peace of mind that comes with knowing that your mortgage rates will stay the same for your full term, go for a fixed-rate mortgage. If you’re willing to speculate that rates will stay the same or decrease, a variable-rate mortgage may be more appealing.
Barry Choi is a personal finance and travel expert. His website moneywehave.com is one of Canada's most trusted sites when it comes to all things related to money and travel. You can reach him on Twitter: @barrychoi.