When you’re preparing to take out a mortgage, it’s important to understand how interest rates may affect your loan. This is especially true in the current economic climate, since we’ve experienced several successive increases in the Bank of Canada’s policy rate, a sort of benchmark that financial institutions use to set their prime rates.
So, what are the benefits of having a variable rate mortgage rather than a fixed rate mortgage, and what products will give you the most flexibility in a changing market?
Historically, variable rate mortgages have proven to be more advantageous than fixed rate mortgages. However, these products were among the first to feel the effects of recent policy rate hikes, which resulted in many mortgage holders paying more toward interest.
This is why it’s important to understand the different types of mortgage rates and make an informed decision that takes into account your financial situation, lifestyle, long-term goals, and risk tolerance.
As the name suggests, fixed interest rates stay the same for the duration of the term you’ve chosen—usually between one and five years—even if mortgage rates change.
While fixed rates are generally a little higher than variable rates, they can be a good option if rates are particularly low or if you want to avoid the possibility of a rate increase that you can’t absorb. If you need to know exactly how much you’ll have to pay every month and predictable payments are central to your financial management strategy, a fixed rate mortgage is a good product to consider.
(Insérer lien vers taux fixes pour maillage interne)
A variable rate mortgage fluctuates with the financial institution’s prime rate, which is used to set variable interest rates for loans, mortgages, and lines of credit. Variable rate mortgage products rise and fall with the Bank of Canada’s policy rate. There are two types of variable rate mortgages: fixed payment and variable payment.
For the past 70 years, closed variable rate loans have, on average, been more effective at reducing the interest burden on households. However, you need to be comfortable with the idea that your interest rate may fluctuate and influence how much of your payment goes to the principal versus interest.
According to a York University study by finance professor Moshe Arye Milevsky, Ph.D., variable rate mortgages were the better option in 90% of cases over a 50-year span. In the sample studied, the average amount of money saved on a $100,000 mortgage amortized over 15 years was $22,000, which is a considerable chunk of change.
In short, if you can tolerate the risk, it’s statistically very likely that you’ll pay significantly less over the term of your loan.
For variable rate mortgages, the penalty is usually equivalent to three months of interest. But with a fixed rate mortgage, the calculation is a little more complex and often results in a much higher penalty—we’re talking about a difference of several thousand dollars.
Hybrid mortgages combine elements of fixed rate and variable rate mortgages to protect borrowers from rate hikes. Your mortgage balance is divided into multiple segments, each with its own terms and conditions regarding amortization, term, interest rate, and payment frequency.
A capped variable rate can also be a good option. With a capped variable rate, your interest rate will never exceed a predetermined threshold. This allows you to take advantage of rate decreases while being sheltered from major rate hikes.
While fixed and variable rate mortgages are familiar terms to most homeowners, there is another potentially promising option out there. Some financial institutions offer variable rate mortgages with fixed payments.
Essentially, your payments stay the same even if interest rates change. When rates go down, a higher percentage of your payment goes toward the principal, which could allow you to get ahead on your mortgage. Conversely, when rates go up, a larger portion of your payment goes toward interest, which could lengthen the term of your loan.
Recent interest rate hikes have changed the game for many homeowners, however, as they have been inching steadily closer to their trigger rates since this year’s rate hikes began.
When payments no longer cover the full interest amount or the loan can no longer be paid off before the end of the amortization period, a mortgage is said to have reached its trigger point. The trigger rate is the interest rate at which the trigger point is reached.
If you’ve taken out a fixed payment variable rate mortgage within the last two years, you’ll likely need to reassess your strategy to stay on track. You have a few different options.
For example, you could increase the amount you’re putting toward your mortgage payments to keep paying down the principal. This will mitigate the financial impact of rising rates when you renew your loan.
Prepaying your mortgage could also be an attractive option if you have the flexibility to do so. This would allow you to pay down your mortgage balance more quickly, reducing your amortization period, and avoid reaching your trigger rate.
Your financial institution can help you do some calculations to keep you from hitting your trigger rate. Don’t hesitate to contact your Multi-Prêts Mortgages broker if your financial institution doesn’t offer the right mortgage product for you.
A mortgage prepayment is a payment made in advance toward the total balance of a mortgage. Bear in mind that some lenders may charge a prepayment penalty, so be sure to check the terms and conditions of your loan before choosing this option.
Lastly, you may want to consider renewing your mortgage to switch to a fixed rate. Keep in mind that after the many rate hikes this year, interest rates are likely to climb even higher. Before you renew, be sure to check your contract for limitations and penalties.
Regardless of the type of mortgage rate you choose, be aware that every option has its own unique characteristics and terms. Your mortgage broker can recommend the right product for your situation.