As Canadians think about buying property, one of the key decisions they must face is whether to opt for a fixed rate vs variable interest rate for their mortgage loans. Each kind of rate has its own strengths and affects the monthly payments on a mortgage loan differently; hence, understanding interest rates is important.
An interest rate refers to the money the lender charges to you for lending you money, expressed as a percentage. To avoid paying interest, you’ll need to pay for the property or item in its entirety upfront. For big purchases like a vehicle or home, most Canadians don’t have the money available to pay for the purchase in full at the time of sale. Borrowers will need to arrange a loan or mortgage loan to pay for those large purchases; this is where a mortgage broker can be a great asset to consult with to assist with the shopping and arranging of a mortgage loan.
Mortgage loan agreements between borrowers and lenders will include details like:
- length of the repayment period (amortization on a mortgage)
- interest rate
- interest rate term
- payment frequency
The interest rate is important to lenders because loaning out money has a cost, and that cost is mitigated by the interest rate plus a little profit for the lender so they can continue to offer loans in the future. When it comes to mortgages, the interest rate usually depends on several factors, such as the borrowers credit history and score, term of the rate, type of property and property use, and whether the rate is a fixed or variable.
While interest rates aren’t exclusive to mortgages, the option between variable and fixed rates is generally in the context of buying a house. Being informed on the kinds of interest rates is good preparation for when you want to buy a property.
Understanding interest rates: the Canada prime interest rate
Before making distinctions between variable and fixed rates, the first thing potential homeowners need to understand is the differences between the overnight rate, prime rate and the 5-year bond yield.
The overnight rate is set by the Bank of Canada (BoC), and it is the rate that banks, credit unions and monoline mortgage lenders use to determine their prime rate. The lenders set the prime rate, typically 2% – 2.25% above the BoC overnight rate; it’s also used to determine their variable rate. The 5-year bond yield usually determines what the lender sets as the 5-year fixed rates; as the bond yields go up and down, the 5-year fixed rate will usually move in lockstep.
Understanding interest rates: rate term, amortization period, and mortgage status
In addition to the prime rate, potential borrowers must also understand rate terms and mortgage repayment status.
The rate term dictates how long the interest on your loan contract is guaranteed. Normally, mortgage terms can vary throughout the amortization period and range from 6 months to 10-year terms, with the most common being a 5-year fixed term. At the end of the term, a new term length and corresponding interest rate can be selected based upon your needs at the time. It is always a good idea to talk to your mortgage broker to ensure the mortgage and rates are still the best to meet your goals before signing any renewal documents with your current lender.
A rate term is different from an amortization period, the latter referring to the amount of time to repay the entire mortgage loan.
In Canada, you can have up to a maximum 25-year amortization period for insured mortgages (these are loans where you put less than 20% down payment to make the purchase).
The 25-year maximum amortization also applies to mortgage loans where you may have more of a down payment than 20%, but if you keep the amortization period at or below 25 years, the lender may also insure these mortgages, making them insurable.
The maximum amortization period for uninsured mortgages is typically 30 years; an uninsured mortgage is one where you have more than a 20% down payment, and the lender does not insure the mortgage. The longer your amortization period, the lower your regular payment will be.
Meanwhile, mortgage repayment status is crucial in discussing prepayment opportunities, which is how much you can pay down on your mortgage on top of your regular payments without incurring an early prepayment charge or penalty. There are two types of mortgage status:
- Open mortgage: An open mortgage lets borrowers pay off or pay down their mortgage at any time without any penalty, either by making extra regular payments or by making lump sum payments all the way up to repay the total outstanding balance. Interest rates are higher in open-rate mortgages because of this flexibility.
- Closed mortgage: With a closed-rate mortgage, borrowers are limited to how much and how large prepayments can be without incurring any penalties, if any prepayments are permitted at all. Typically, standard closed mortgages will permit regular payments to be increased by 15% – 20% and annual lump sum payments of 15% – 20%.
Additionally, there are penalties for pre-payment outside of the initial pre-payment agreement; for example, if you prepay 25% instead of 15%, the additional 10% will incur a penalty. A key benefit however is that closed mortgages have lower interest rates than open mortgages.
What is a variable rate?
Variable rates are a type of mortgage rate that changes up or down along with changes to the lender’s prime rate. This means that if the lender changes their prime rate by 0.25% up or down, then the borrower’s interest rate will also change by 0.25% up or down. Depending on the type of variable rate the borrower has, amortization period, or payment schedule.
One thing all variable rates share is that the relationship to the prime rate is locked in for the term. For example, if you selected a variable rate that is offered at prime – 0.95%, and the prime rate is 7.20%, then your rate is 6.25%. If the prime rate changes downward by 0.25%, then the rate on the mortgage will also go down by the same percentage.
Variable mortgage rates are a great option for those who don’t mind having their mortgage payment change overtime.
There are two types of variable rate:
- Variable rate mortgages (VRM): your monthly payment will remain the same despite changing prime rates. The lender will determine how the changing rate impacts your mortgage; they will adjust the ratio of how much of your payment goes towards interest and how much goes towards the principal, or they will adjust your amortization period length.
- Adjustable-rate mortgage (ARM): in the type, the amortization period stays the same even if the prime rate changes.
This happens because the monthly payments automatically adjust up or down with the change to the prime rate. Almost all variable rate mortgages are closed mortgages and come with a 3-month interest penalty if the mortgage is refinanced or repaid prior to the agreed-upon time.
What is a fixed rate?
Fixed rate mortgages can be considered the opposite of variable rates. While variable rates may change over the course of a mortgage term, a fixed mortgage rate stays the same for the selected term regardless of changes to the prime rate. Because the rate stays constant, the regular payment stays constant as well, making managing a budget much easier. Fixed rate is a more popular option among borrowers because it eases budgeting anxiety.
Fixed rates are almost always closed mortgages, which means refinancing or re-negotiating the mortgage before the end of the term will incur a penalty.
Comparing fixed and variable rates
Whether you’re getting your first mortgage or an additional mortgage, understanding interest rates and choosing the kind that suits you best is crucial. In addition, the choice between a fixed rate vs variable rate interest can significantly affect your mortgage terms and payments.
After learning about what variable interest rates and fixed interest rates are, understanding what kind of benefits they bring is the next step.
Changing the type of interest rate
Mortgage terms are available in several term lengths. At the end of the term, homeowners must either renew into a new term with the same lender or transfer to a new lender and select a new rate and term. This is another benefit of working with a mortgage broker; they can shop around for you to find the best mortgage rates and terms that can meet your financial needs.
Conclusion: the interest rate for your mortgage
The choice between a fixed rate vs variable rate for your mortgage is an important consideration for your finances. Understanding interest rates involves examining your current financial situation and the current economic environment. Both fixed and variable rates offer advantages, but knowing what you want is the most essential element.
Frequently Asked Questions
Fixed mortgages are more popular than variable mortgages, but home buyers statistically pay less in total with a variable rate over the life of the mortgage. Each homeowner has a different vision on what “better” means for them. Likewise, every homeowner is in a unique financial position in a different economic situation, so only they will be able to discern for themselves if variable or fixed rates are better.
Typically, variable rates are lower than their fixed rate counterparts, but they have the potential to rise higher than fixed rates during the term as experienced from 2022 to 2023. Over the long term, variable rates generally result in less interest being paid, but borrowers have to be willing and able to manage rising interest rates and their impacts.