Navigating the world of mortgages can be a daunting task, especially when it comes to understanding the different types of interest rates. Fixed, variable, and adjustable rate mortgages each have their unique characteristics and benefits. Here we’ll clarify the differences between the three types of mortgages, helping you make an informed decisions about what’s right for you.
Fixed Rate Mortgages
A fixed rate mortgage is a loan with a consistent interest rate throughout its term. This means that the monthly payment remains the same for the term of the loan, regardless of market fluctuations. Fixed rate mortgages are typically offered for terms of 1-5 years, providing homeowners with the stability of a predictable monthly payment.
Pros of Fixed Rate Mortgages
- Predictable monthly payments: The fixed rate ensures that your monthly payment remains constant, making budgeting easier and more manageable.
- Lower interest rates: Fixed rate mortgages currently come with lower interest rates compared to other types of mortgages, which can save you money over the life of the loan.
- Long-term financial planning: The stability of a fixed rate mortgage allows homeowners to plan their finances for the long term, knowing their monthly payments will not change.
Cons of Fixed Rate Mortgages
- Limited flexibility: The fixed rate mortgage’s predictability comes at the cost of limited flexibility. If interest rates were to decrease significantly, homeowners with fixed rate mortgages would not be able to take advantage of lower payments without paying a penalty to break the mortgage early. The penalty is the greater of 3 months interest or the interest rate differential, the latter can be very costly if rates have dropped.
Variable Rate Mortgages
A variable rate mortgage has an interest rate that changes based on the Bank of Canada prime rate. The initial interest rate is typically lower than fixed rate mortgages, but it can fluctuate over the life of the loan. At this time after several recent increases it is actually higher than fixed rate mortgage rates. With a variable rate mortgage your monthly payment remains the same and any increases or decreases to the prime rate will affect how much of your mortgage principal is being paid with each payment. As we’ve seen this past year after several interest rate increases, some borrowers with variable rate mortgages have been paying no mortgage principal and all of their payments have been going towards interest.
Pros of Variable Rate Mortgages
- Potential for savings over time: Historically, variable rate mortgages have performed better over the term than fixed rate mortgages.
- Flexibility: The variable rate mortgage offers more flexibility compared to fixed rate mortgages, allowing homeowners to take advantage of lower interest rates if they occur while only paying a 3 months interest penalty.
Cons of Variable Rate Mortgages
- Higher risk: The potential for interest rates to rise could result in not paying off any of your mortgage principal. In some cases a trigger rate is hit where the monthly payment is not enough to pay the interest, in these cases your lender will let you know your options which could include increasing your monthly payment or pushing out your amortization.
- Lack of long-term planning: The uncertainty of variable rate mortgages makes it difficult for homeowners to plan their finances for the long term.
Adjustable Rate Mortgages
An adjustable rate mortgage (ARM) is a type of variable rate mortgage with a predetermined adjustment formula. The interest rate adjusts periodically based on the Bank of Canada prime rate. ARMs often start with a lower interest rate than fixed rate mortgages but can increase over time as we’ve seen recently, making them suitable for homeowners who plan to sell or refinance their home before the adjustment period.
Pros of Adjustable Rate Mortgages
- Lower initial payments: Similar to variable rate mortgages, ARMs often have lower initial interest rates, leading to lower monthly payments. This is generally true although with several increases over the last 2 years they are now higher.
- Potential for lower payments: If interest rates decrease, homeowners with ARMs will see their monthly payments decrease as well.
- Suitable for short-term homeownership: ARMs are ideal for homeowners who plan to sell or refinance their home in the near future. The penalty is only 3 months interest and can save thousands compared to the penalty on a fixed rate mortgage.
Cons of Adjustable Rate Mortgages
- Unpredictable payments: Changing interest rates can lead to unpredictable monthly payments, making budgeting more challenging.
- Higher risk: The potential for interest rates to rise could result in higher monthly payments and increased financial strain.
- Limited long-term planning: The uncertainty of adjustable rate mortgages makes it difficult for homeowners to plan their finances for the long term.
Conclusion
Understanding the differences between fixed, variable, and adjustable rate mortgages is crucial to make informed decisions about your home financing. Each type of mortgage has its unique advantages and disadvantages, and it’s essential to consider factors such as your financial goals, budget, and long-term plans when choosing the right mortgage for you.