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What are the different types of mortgages and when would I use them?
Dated: December 4 2021
Financing the purchase of a new home comes with several decisions that need to be made. One of the biggest decisions for a potential home buyer is around what type of mortgage they should secure. It’s the age-old debate of variable or fixed. There are two schools of thought and it’s never a “one size fits all” approach. It comes down to understanding the ins and outs of both types of mortgages and assessing based on your own risk tolerance and which product is best suited for your needs. I will explain the difference between the two below.
A fixed-rate mortgage can be as short as 6 months and as long as 10 years. Typically, the longer the term, the higher the interest rate is. A fixed-rate is just that, it’s fixed and locked in for the period of time that you select. That means that during that term, your payments, interest rate, and terms of lending remain the same. A fixed-rate mortgage locks you in providing you assurances against rising interest rates. For many borrowers, that peace of mind is invaluable. Most borrowers opt for a 5-year fixed term if selecting a fixed-rate option to maximize this protection. This type of product allows the borrower to better forecast where they will be financially in 5 years, which makes this option very appealing. In addition, borrowers will find that a lot of banks offer promotions on 5-year fixed term mortgages, making it the most common term amongst fixed-rate products.
The one drawback to a fixed-rate to consider is how penalties are calculated. For example, a client would pay a penalty if they were to break their mortgage prior to the end date of the term they selected. If the borrower were to sell the property, look to refinance or want to take advantage of a lower rate, they could face a significant penalty fee. Fixed-rate penalties can be 10-20x more than if they were to break a variable-rate type mortgage.
Variable-rate mortgages are tied to the bank’s prime rates, which in turn are tied to the Bank of Canada’s overnight lending rate. When a borrower secures a variable-rate mortgage, they are not approved for a set interest rate but rather a discount off the prime rate. Even as the prime rate increases or decreases over time, that discount remains the same. For example, the current prime rate sits at 2.45%. An average discount a variable-rate borrower may be approved for is 1.00% below prime (for an effective interest rate of 1.45%). If that prime rate increases to 2.95%, your discount of 1.00% below prime remains and your rate would change to 1.95%. The most common term for a variable-rate mortgage is 5 years (some lenders offer a 3-year variable-rate term). Over a 5-year period, your discount will never change.
The Bank of Canada meets 8 times a year, so with a variable-rate mortgage, there are 8 possibilities that the interest rate could increase or decrease over a 12-month period. While the possibility exists that rates could fluctuate as much as 8 times per year, it’s highly unlikely that the Bank of Canada would change interest rates that many times over that short of a period of time. Typically, when the Bank of Canada raises or lowers interest rates, it tends to be in .25% increments, so it is not like you will wake up to find your interest rate 1.00% higher overnight.
For a consumer looking at a variable-rate mortgage, it’s important to understand that some variable-rate payments fluctuate, and some stay the same and do not change, only the allotment of principal and interest change. For a variable-rate payment that stays the same, even with a rising interest rate environment, it could mean that the borrower is in for a shock when they see how little principal they have paid off their mortgage over the term.
One key feature that most variable-rate mortgages provide is for a borrower to lock in or convert their mortgage to a fixed-rate at any point in time throughout the term of the mortgage. A variable-rate borrower can lock into whatever fixed-rate is being offered at the time they decide to convert their mortgage, and there are no penalties to do this. This helps protect borrowers in the event interest rates start to climb.
There is no right or wrong answer when a potential borrower asks which mortgage product option is best for them. It’s an individual decision based on several factors including the ability to handle higher payments in the event interest rates rise. As I mentioned above, some borrowers find comfort knowing exactly what their interest rate and payment will be for the term that they select and therefore lean towards a fixed-rate. On the other hand, a borrower may have the ability to handle changes to payments and interest rates and prefer the added flexibility of the variable-rate mortgage. Again, it’s not a one size fits all approach, so it’s best to ensure you have reviewed the pros and cons of each option closely with your mortgage broker when deciding on the final product you should take.
If you have any questions or would like to discuss anything mortgage-related, please do not hesitate to email me at email@example.com.
Published by Jason Friesen
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