Filling the gap
The gap between Fixed vs Variable Rate Mortgage products has narrowed in recent years. And while fixed rates are starting to rise they offer certainty in a monthly payment. On the flip-side, variable rates remain low, but are the riskier of the two choices – so how do you choose?
Your income, lifestyle and risk tolerance will weigh heavily on your decision and will inevitably determine which product suits your circumstance.
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Risk versus reward
The appeal of variable-rate mortgages is that the interest rate is typically lower than that of fixed-rate products. However, the main drawback is the risk involved. Without warning, rates could increase or decrease.
One of the quickest ways to determine if a variable-rate mortgage product is right for you is whether or not you can afford rate increases, says Michael Cameron, a broker with Axiom Mortgage Partners in Edmonton.
The first thing you should assess is your current income, earnings and potential for increase of earnings, says Gerri Vaughan, a broker with Invis in Edmonton. “Can they weather any storms – rate increases or decreases?”
If you can comfortably afford mortgage rates that are two per cent higher than what you’d pay on your variable, then you may be OK, says Cameron. But proceed with caution. “Rates right now are at historic lows. So low that it’s quite conceivable you could see rates double in the next little while,” he says.
Understanding the risk involved is a prerequisite
If you’ve decided you can afford a variable-rate mortgage, the next thing you will want to determine is if a variable-rate mortgage fits your personality. If you’re the type of person who can’t sleep at night knowing your rate may go up, even slightly, a variable-rate mortgage may not be the best option for you, says Cameron.
One thing you can do to mitigate risk and reap some rewards of choosing a variable-rate product is to fix your payment at a set amount higher than the minimum requirement, says Cameron.
Michelle Brienza of Michelle Mortgages is a strong proponent of variable-rate products. She says 70 per cent of her clients choose variable.
“If you pick a variable-rate product and make the minimum monthly payment, it doesn’t work,” Brienza says.
Vaughan suggests setting your variable-rate mortgage payment at the current five-year fixed rate. Not only will you have a buffer if rates rise, but it will allow you take advantage of the lower variable rate by allocating more of your payment to pay down the principal.
“You’ll be ahead in terms of amortization, you’ll be using your prepayment privileges (many Canadians don’t because they can’t afford to) and if rates begin to rise, you can lock in for at least the length of the remainder of your mortgage term, so you’ll be getting the best of both worlds,” says Brienza.
While it may seem like a good idea to take advantage of a variable-rate product while rates are low and switch to fixed when rates begin to rise, some mortgage specialists caution against it.
“I don’t suggest anyone’s going to have a whole lot of luck in timing the market. In my opinion, you take a variable-rate product because you believe over time, the variable rate is going to average lower than your longer-term fixed,” says Cameron. “You can have 10 phDs in economics and you’re still not going to know what rates are going to do and when.”
However, some people will still take variable with plans to watch the rate and convert it when rates start to rise. But remember, when you convert it, you convert it at the rate at the time of conversion, says Vaughan. “If rates turn around and start going up, they’ll go up a lot faster than they came down so you may miss the boat,” she says.
Moreover, conversion rates are something to ask about with variable products. If you have an open variable product that you can convert at any time, ensure you know what rate you’ll receive if you switch to a fixed-rate product. Is it the best fixed rate available, or a posted fixed rate? The posted rate may be 5.79 per cent but there may be a 3.79 per cent fixed rate available, says Cameron.
“Anyone who would have selected a variable-rate product over the last 10 years will have done very well,” says John Turner, director of mortgages at Bank of Montreal in Toronto.
“Considering a variable-rate mortgage is still a good thing given the rate difference. But we’re likely at the bottom end of the interest rate environment.”
While there might be a little more downward movement in the future, it becomes a waiting game, he says.
The popular choice
In the past, variable rates used to be calculated prime minus, while today they’re prime plus, narrowing the spread, which is the difference between the interest rate on a fixed-rate mortgage or a variable-rate mortgage. In May, the spread between a current variable rate and a fixed rate was negligible.
Five-year fixed products have historically been popular in Canada. But because of this narrowing and drop in rates, for some, the decision to choose a fixed-rate product is a no-brainer.
For instance, at the time of publication, variable rates were hovering around three per cent, while fixed-rate products could be found for just under four per cent.
“The risk (of variable-rate products) versus the reward is not substantial enough, in my opinion, to take the risk,” says Cameron, who in May told Buying Your First Home that when fixed rates are within a percentage point of variable rates, fixed is the way to go.
While most people are risk-averse, first-time buyers nearing the beginning or growth of their families are more likely to choose a fixed mortgage because it means they can budget for the length of their mortgage term, says Turner.
In addition, the costs of purchasing a new home and maintaining it can swallow a large portion of their income, not leaving a lot for possible rate increases, he says.
If there’s a particular rate and payment you feel good with and know you can afford, then most people will prefer the peace of mind, says Turner.
“I always tell people that if you’re the type of person that always buys the extended warranty, then a variable-rate product is probably not for you,” says Cameron.
Consider this analogy from Cameron: Look at the difference between the fixed rate and the variable rate as your insurance premium. Assuming your variable is three per cent and your fixed is 3.75 per cent, you’re paying a 0.75 per cent insurance premium. If that works out to a $75 a month difference in payment, you’re paying $75 a month to have the peace of mind and security to know that for the next number of years your payments aren’t going to change.
“Of course, the variable rate today doesn’t necessarily mean it’s going to be the variable rate tomorrow,” he says. “If you can boil it down to a dollar per month cost, it makes it a lot easier for people to make a decision.”
Locking in your Mortgage
Once you’ve made a decision about rates, you’ll need to decide on the length of the mortgage term.
The length of time you expect to be in a property may have a bearing on the length of your mortgage term. Some buyers will decide they don’t want to worry about renegotiating their mortgage payment for the length of time they plan to live in the house, says Vaughan.
The average length of a mortgage term is five years for both fixed vs Variable Rate Mortgages.
In Vaughan’s experience, some people will take a term to match elections, as historically, interest rates tend to be lower during election years. This isn’t always the case, but it is public perception, she says.
Flexible Mortgage Rate
While rates are important, flexibility and features may be the determining factor for you when choosing your mortgage product.
The ability to put lump-sum payments down on your principal is what’s usually referred to as prepayment privileges. Banks and lenders differ on the amount usually ranging from 15 per cent to 20 per cent of the amount owed. Be sure to check the frequency because some lenders only allow this payment to be made once per year, which may not be convenient for you. So, if they allow you to prepay $10,000, and you opt for $5,000, you won’t be allowed to pay off another $5,000 in the same year. Lump-sum payments are traditionally annualized, meaning you can’t skip a year and then double it the next year.
You may want the flexibility to put down large lump-sum payments if you receive a bonus through work, a tax refund, an inheritance or just come into some extra money, says Vaughan.
“The other thing that I’ll typically advise them to do is round off their payment,” she says. “I’m a round number thinker. So if the payment is $873, I’ll round that number up to $900 because you won’t feel it in your budget, but that extra $27 is going to pay down your principal that much faster.”
You may also want to see if you have the option to increase your payments. With some products you can increase your payment by 10 per cent to 20 per cent.
“Price is important. Getting a great rate is important. You can have the greatest rate in the market on a product but unfortunately when it comes to your life and events all of a sudden you can be stuck,” says Turner. “So I think it’s important to look at features. What would you use or could you use as opposed to the nice-to-have.”
While uncommon, some lenders offer payment holidays. For instance, if a borrower is going on maternity leave or paternity leave, Bank of Montreal has a program called family care, which allows a customer to defer four months’ worth of payments.
Another feature available is re-borrowing capability. How important is re-borrowing to you? As you pay down the mortgage, can you get access to the cash again? Not all lenders will offer this option. But it might be one worth looking at.
“For instance, if you receive a bonus for $20,000 and put it toward your mortgage, and then your roof falls in and requires $10,000 worth of repairs, can you retrieve the prepayment on your mortgage?” asks Turner, whose company offers a feature that would allow borrowers to do so.
If there’s a possibility you’ll move before your mortgage term is up, you might want to consider a portable mortgage product. Not all mortgages are portable so be sure to ask your mortgage specialist if the products you’re considering can be transferred to a new home. If you’re considering a closed product and there’s some type of penalty you could incur, ensure you get the details of the penalty upfront, says Turner.
The standard penalty to pay out a fixed-rate mortgage is either three months’ interest or interest rate differential – whichever is greater of the two.
If you got a mortgage two years ago when rates were at 5.5 per cent or six per cent and if you wanted to rewrite that mortgage to current rates which are around four per cent you are looking at an interest rate differential, which could be thousands of dollars depending on your mortgage, says Vaughan.
Basically what you’re doing is prepaying those interest charges on your contract – the difference between your contract rate and your current rate – to your maturity, she says.
It’s not advantageous to buy out your mortgage, unless you have less than two years to maturity, Vaughan says. If you still have four years until maturity, you’re only really buying an extra year as you move into a five-year term. If you don’t have the cash to pay that interest rate differential, then you have to apply it to the mortgage and then you’re paying interest on interest, she says.
So if you’ve got the cash, Vaughan advises to make a principal payment on your mortgage and don’t buy the rate down.
Break it down (Source: John Turner, Bank of Montreal)
Variable-rate products appeal to some because the rate is calculated based on prime and is typically lower than the fixed rate. Payments are generally fixed over a period of time (eg. three years). As interest rates go down more of the mortgage payment goes to principal. But as interest rates go up less goes to principal. This means that your Amortization period (the number of years you’ve selected to repay the mortgage (both principal and interest) could be longer or shorter if interest rates have risen or fallen since the start of the term.
Open variable: Being open allows you to put down as much as you want, or pay off the entire mortgage at any time. It also lets you change to another term at any time, without charge. Payments are generally fixed throughout the term. This product is ideal for those who have swings in their cash-flow that would allow them to pay their mortgage off in lump sums, are thinking of selling their home, wish to prepay more than 20 per cent of their mortgage amount or believe rates will decline. However, expect higher rates with an open product than a closed product of the same term length.
Closed variable: With closed products, the payments are generally fixed for the term. It’s important to know what your prepayment options are. Can you make lump-sum payments? How much and how often? Typically a closed mortgage will have limited prepayment options.
The appeal of fixed mortgages is that they allow you to accurately budget. You know what your mortgage payment will be for a determined length of time, as well as how and when your mortgage will be paid in full.
Open fixed: You’re able to prepay in full or in part at any time with no prepayment charge. In addition, you can change to another term at any time without charge. Ideal for those who want maximum flexibility, are thinking of selling their home, wish to prepay more than 20 per cent of the mortgage amount or believe rates will decline.
Closed fixed: Your interest rate and payments are fixed for the term you choose. This product is ideal for the budget-conscious who prefer peace of mind, knowing rates will not rise during the term. They also want a lower rate than an open mortgage of the same term.
Convertible fixed: Let’s you convert to a closed term of one year or longer at any time, without charge. This product may be for you if you want to keep your options open and want a lower rate than an open mortgage of the same term. Your prepayment privileges are less flexible than those of an open nature.
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