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One of the most common dilemmas for homebuyers is deciding between a fixed-rate or variable-rate mortgage. Your choice will depend largely on your financial situation and how much risk you're willing to take. Here's a breakdown of the two options to help you make a well-informed decision.

Key Points

• Fixed-Rate Mortgage: The interest rate stays consistent for the entire term of the mortgage, providing predictable payments.

• Variable-Rate Mortgage: The interest rate changes based on fluctuations in the prime rate, leading to potential variations in monthly payments.

• Best for Stability: Fixed-rate mortgages are ideal for individuals who value consistent payments and long-term stability.

• Best for Flexibility: Variable-rate mortgages can be advantageous if interest rates are expected to decrease or if you prefer greater flexibility in loan terms.

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What Is a Fixed-Rate Mortgage?

A fixed-rate mortgage ensures that your monthly payment amounts remain consistent throughout the loan term. Each payment contributes to both the principal (the original loan amount) and the interest (the cost of borrowing).

While the total payment amount stays the same every month, the distribution between principal and interest changes over time. Initially, a larger portion of your payments goes toward interest, but as you pay down your mortgage, more of each payment is applied to the principal balance.

To illustrate how these payments shift, here’s a partial amortization table for a 5-year fixed-rate mortgage of $300,000 with a 30-year amortization period and an interest rate of 4.2%.

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Pros and Cons of a Variable Mortgage Rate

Variable-rate mortgages come with notable benefits, but they also have potential downsides that borrowers should weigh carefully.

Pros

• Potential Cost Savings:

  • When the prime rate decreases, so does the interest rate on your mortgage.

  • This means you could pay less in interest over time, allowing more of your payment to reduce the principal balance.

  • This can make a variable rate more affordable compared to a fixed rate during favorable economic conditions.

• Greater Flexibility:

  • Many lenders allow you to switch to a fixed rate during your term without incurring penalty fees, giving you the ability to lock in a stable rate if needed.

Cons

• Higher Costs if Rates Increase:

  • If the prime rate rises, the interest rate on your mortgage will also increase, making it more expensive over time.

• Unpredictable Payments:

  • For open variable-rate mortgages, rate increases can lead to fluctuating monthly payments.

  • This variability can make it harder to budget and manage your finances, especially if you have a tight or fixed income.

Pros and Cons of a Fixed-Rate Mortgage

While fixed-rate mortgages typically come with slightly higher borrowing costs compared to variable-rate mortgages, they offer distinct advantages and disadvantages that can help you decide if they’re the right choice for you.

Pros

• Stable Payments: Your monthly mortgage payments remain consistent throughout the term, making it easier to budget and plan.

• Locked-In Rate: Your interest rate won’t change during the term, protecting you from rate hikes. If interest rates rise significantly, your fixed rate ensures stability and peace of mind.

Cons

• Potentially Higher Costs: Fixed-rate mortgages often come with a premium for their predictability, meaning you might pay more in interest over the life of the loan compared to a variable-rate option.

• Missed Opportunities: If interest rates drop during your term, you won’t benefit from the lower rates unless you break your mortgage early. Doing so typically incurs penalty fees, which can be costly..

How Much Can I Afford to Borrow for My Mortgage?

The mortgage stress test evaluates not only your ability to handle rising interest rates but also considers your overall debt profile. Two key ratios play a crucial role in determining your mortgage affordability:

1. Gross Debt Service (GDS)

   • This represents the percentage of your income allocated to housing expenses, including mortgage or rent payments, utilities, and property taxes.

   • Your GDS should be less than 39% of your monthly income.

2. Total Debt Service (TDS)

   • This measures the percentage of your income allocated to all debts, including housing costs and other obligations like credit card payments, student loans, and car loans.

   • Your TDS should be less than 44% of your monthly income.

By keeping these ratios within the recommended limits, you can better determine how much you can afford to borrow for your mortgage.

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What is a Variable-Rate Mortgage?

A Variable-Rate Mortgage is:

A variable-rate mortgage fluctuates alongside changes in the prime rate. When the prime rate adjusts due to economic conditions, the interest rate on your mortgage will also change. This means that your payments or the portion allocated to interest may vary throughout the loan term.

How Is a Variable-Rate Mortgage Determined?

The variable rate is directly tied to Canada’s prime rate, which serves as a benchmark set by major banks for determining the rates on various credit products.

The prime rate itself is influenced by the overnight rate, which is established by the Bank of Canada based on the cost of borrowing for major financial institutions.

Variable rates are often presented as the prime rate minus a discount. For example, if the current prime rate is 5.95% and your bank offers a discount of 1.2%, your interest rate would be:
5.95% – 1.20% = 4.75%.

Types of Variable-Rate Mortgages

1. Adjustable Payments with a Variable Rate

   • The amount allocated to the principal remains consistent.

   • Fluctuations in interest rates will adjust the interest portion of your payments.

   • Payments will increase or decrease as rates change, which can be challenging for individuals with tight budgets or irregular income.

2. Fixed Payments with a Variable Rate

   • Total payment amounts remain the same regardless of rate changes.

   • If rates increase, a larger portion of your payment goes toward interest, potentially lengthening the time to pay off the principal.

   • If rates decrease, a smaller portion of your payment covers interest, allowing more to go toward the principal.

   Trigger Point
   If rates rise significantly to reach a certain threshold, known as the trigger point, your payments may increase to ensure the mortgage is paid off within the amortization period.

This option suits those seeking stable payments while hoping to benefit from declining rates, with a safeguard in place for extreme rate increases.

How to Choose Between a Fixed and Variable Mortgage Rate

Selecting between a fixed and variable-rate mortgage requires careful consideration of your financial situation, goals, and market conditions. Here's how to decide:

Opt for a Variable-Rate Mortgage if:

• Rates Are Expected to Decrease:
  If the market outlook suggests a drop in interest rates, a variable-rate mortgage could save you money over time.

• You’re Comfortable with Payment Changes:
  You can manage potential fluctuations in your monthly mortgage payments without financial strain.

• You May Sell Soon:
  If there’s a chance you’ll sell your property before the end of the mortgage term, the flexibility of a variable rate may suit your plans.

Opt for a Fixed-Rate Mortgage if:

• Rates Are Low but Stable:
  Locking in a low fixed rate provides peace of mind if rates aren’t expected to drop significantly.

• You Value Stability:
  Fixed rates offer predictable payments, making it easier to budget over the mortgage term.

• You’re Staying Long-Term:
  If you plan to remain in your home for several years, a fixed rate can provide financial consistency.

Pro Tip: Secure Your Rate Before Renewal

As your mortgage term nears its end, consider locking in a new rate well in advance. This protects you from potential rate hikes and gives you time to explore the best options for your next term. Many lenders offer rate locks for periods ranging from 3 to 6 months, making this a smart move for long-term savings and planning.

Variable vs Fixed Rate Mortgages - FAQs

Bottom Line

Choosing the right mortgage rate depends on your financial situation, risk tolerance, and market conditions. If interest rates are expected to drop and you're comfortable with fluctuations in your payments, a variable-rate mortgage could be ideal. However, if you prefer predictable payments and less risk, a fixed-rate mortgage might be the better choice. Ultimately, your bank can assist in helping you decide which option fits your needs best.

What does it mean to lock in your mortgage interest rate?

A "rate lock" is when you secure the interest rate offered by your lender for a set period, usually between 30 to 120 days. This is beneficial if the rate is favorable and you anticipate rates rising in the near future.

What mortgage terms are available with a variable-rate mortgage?

Variable-rate mortgages are typically offered in 5-year terms, although 1 to 3-year terms may also be available.

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What mortgage terms are available with a fixed-rate mortgage?

Fixed-rate mortgages commonly come with 5-year terms, though terms can range from 6 months to 10 years.

Note: ibeloan.com is a referral service and does not arrange, underwrite, or broker mortgages.

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