Fixed or Variable?
When you apply for a mortgage you must take an interest term that is either “fixed rate” or “variable.” The term of the mortgage is different from the amortization. The amortization refers to the length of time the mortgage payments are repaid over, usually this is up to 25 or 30 years.
What is the difference between a fixed rate & a variable rate mortgage?
A fixed rate mortgage will have the same interest rate for the time you choose as the term. Available fixed terms are usually 1 to 10 years.
A variable rate mortgage will fluctuate with the Canadian prime rate. These are usually available as 3 or 5 year terms. While often lower than the fixed rates at the time you arrange financing, there is more risk involved with this mortgage as the rate is not guaranteed. The rate will float up or down reflective of prevailing economic conditions. The Canadian prime rate is reviewed every 6 weeks by the Bank of Canada. The rate setting policy is influenced by the inflation rate. The Bank of Canada has an inflation target of 2%. If there is upward pressure on inflation, this puts upward pressure on the prime rate.
The terms are like closed interest rate contracts. You are in effect, telling the bank that they will receive a source of revenue from you for the term chosen, so they re-invest that money with the anticipation that you will keep the interest rate term for the length of time chosen. If you decide to pay off the mortgage prior to the term maturity date, the bank will charge you a penalty that you can consider their “replacement cost of funds.” Both fixed and variable options are subject to prepayment penalties if you pay your mortgage off before the term is up for renewal.
The mortgage penalties in Canada are standard industry wide. The banks will charge you the greater of 3 months’ interest or the interest rate differential (IRD) for fixed rate mortgages, and 3 months’ interest for variable rate. What is not standard is how the IRD is calculated. Monoline lenders often have a lower replacement cost of funds which can translate to a lower IRD calculation. Click here for a great 3 minute video published by the Globe and Mail that illustrates the difference between 3 months’ interest and the IRD.
The IRD is the bank’s loss of interest for the time remaining in the term. So if you take a 5 year fixed and pay it off after 3 years, either from your own resources, or by sale, the bank will calculate the IRD by comparing your rate, with the current rate for 2 years, and charge that on the balance to the end of the term. A key factor in how the IRD is calculated is the rate that the lender uses in the comparison, ie discounted or posted. Using a posted rate in the comparison increases the differential which increases the penalty.
The estimate for 3 months interest is approximately 2 months worth of payments.
Also worth noting is that for interest terms registered for 10 years, the maximum penalty that can be charged after the 5th anniversary is 3 months’ interest. The IRD does not apply.
Click here for more information from the Financial Consumer Agency of Canada regarding information on breaking your mortgage contract.
When considering your rate choices, interest rate risk and penalty risk are worth taking into consideration
Interest rate risk is the potential of upward pressure on interest rates which leads to increased borrowing costs, and potentially higher mortgage payments. Taking a longer, fixed rate mortgage term helps with lowering this risk. Many people have different reasons for choosing to “lock in” their mortgage rate; fixed income, low risk tolerance, desire for stability, and qualifying for financing are all valid reasons.
Penalty risk is the potential of paying a large penalty if you need to sell your property or switch lenders/refinance before the term is up for renewal. The amount of the penalty depends on how much your mortgage balance is, how much time is left in your term, and what current interest rates are in comparison to the rate you have on your mortgage. Taking a shorter term mortgage, ie 1 or 2 years, or going variable are options you have to try to reduce some of the penalty risk.
What is right for you? Choosing fixed or variable rate financing is unique and case by case based on individual requirements. Ask yourself if this is a short term or long term investment? How much interest rate fluctuation can I handle in both cash flow and comfort level? Where are interest rates today? Is the monthly payment manageable? These are all questions that help you to make the right decision.
Here is an information page from the Bank of Canada explaining What’s behind your mortgage rate.