When looking to acquire a mortgage, the first major decision you’ll have to make is whether to go for a fixed-rate or variable-rate. Both types of mortgages have their pros and cons, so it’s worth exploring how they differ so that you can confidently select the one that is the best fit for you.
The difference between a fixed-rate and variable-rate mortgage
A fixed-rate mortgage means that the interest rate of the mortgage will remain fixed for the term of the mortgage. This also means your mortgage payments will remain the same, so you’ll never be caught off guard by any unexpected changes.
A variable-rate mortgage means that the interest rate of the mortgage will vary throughout the term of the mortgage. The initial rate that is set is based on the prime, plus or minus a certain percentage. The interest rate that you’ll end up paying will fluctuate over the term of the mortgage, since the prime rate that it’s tied to also fluctuates. As the interest rate varies, your mortgage payments will increase or decrease
Pros and cons of a fixed-rate mortgage
A fixed-rate mortgage is a blessing for homeowners who value stability, predictability and are generally risk averse. Since payments remain the same throughout the term (which can be as long as 10 years), they make household budgeting a lot easier, allowing for more concrete financial planning without the stress of unexpected spikes.
Opting for a mortgage with a fixed-rate offers peace of mind when interest rates start climbing higher, particularly after a prolonged recession. Because you’re locked in with a set rate, your mortgage payments are shielded from these rate increases, allowing you to spend your money on a car, vacation, college tuition, etc, without putting yourself in a financially perilous situation.
Despite the certainty of predictable payments, fixed-rate mortgages come with some drawbacks.
First, the rates are generally higher than those on their variable-rate counterparts. They get particularly steep as the term of the mortgage increases.
Second, the penalty to break your mortgage is a lot higher and is based on the greater amount of either Interest Rate Differential (IRD) or 3 months of interest. In most cases IRD will be the higher amount and can be a high price to pay if you want to break your mortgage. IRD is calculated at the time you are breaking your mortgage and takes into account current interest rates at the time.
Pros and cons of a variable-rate mortgage
A variable-rate mortgage is an ideal option for those who don’t mind paying a higher interest rate and having their payments increase. Households that earn a healthy income can ride out fluctuations in mortgage payments; they have the means to adjust their budgets and won’t experience financial hardships should rates start ticking up. And if interest rates decrease, so much the better – their overall payments will decrease.
The interest rates attached to variable-rate mortgages are usually lower than those on fixed-rate mortgages, making them an attractive bargain. They offer a tremendous benefit to those who would otherwise be unable to make the payments on the more expensive fixed-rate variety.
Variable-rate mortgages can become problematic, however, if rates start increasing. What previously looked like a safe and cheap mortgage contract may turn into something that can put a strain on your finances. Should rates start climbing at an accelerated rate, the impact on your payments could be quite severe, the worst-case scenario being you defaulting on your mortgage.
What is the best mortgage for you: fixed-rate or variable-rate?
Before making the decision to choose one or the other, it’s worth examining your personal and financial situation:
- Assess your income and potential for increase of earnings. Will you be able to afford interest rate increases? How high can interest rates go before they become a burden?
- Which type of mortgage best fits your personality? Are you conservative or aggressive when it comes to risk-taking? Does the thought of interest rates increasing cause you to worry? Are you strict about adhering to a budget?
- What is the current state of the mortgage and real estate market? Do the rates on variable-rate mortgages differ by a significant amount when compared to fixed-rate mortgages? Is the risk versus reward of a variable-rate mortgage substantial enough at this point in time? Be sure to shop around and avail yourself of the many mortgage comparison websites available to determine which type of mortgage is the most economical at this point in time.
- While rates are important, other features of your mortgage should also be taken into consideration, such as prepayment privileges, payment holidays, portability, and the option to increase your payments. Depending on your personal needs and circumstances, these additional mortgage features can help you make your decision.