Buying a home with the assistance of your real estate agent may almost always require taking out a mortgage from a reputable lender. The two major options are fixed and variable mortgage rates. While it may be tempting to accept the lowest rate given, this is not the case. Both types of mortgages have advantages and disadvantages, which is why you should understand how fixed-rate and variable-rate mortgages operate before making a selection.
What is a fixed-rate mortgage?
As the name implies, a fixed-rate mortgage has the same interest rate for the duration of the loan. The term of your mortgage contract is its duration. It might last anywhere from a few months to several years. Fixed-rate mortgages may have higher interest rates than variable-rate mortgages, but they are a preferable alternative if interest rates are now at an all-time low, and you want to lock in your rate and avoid any potential future hikes. It would be best to rather budget for constant and predictable payments with the same principal-to-interest ratio regardless of market volatility.
Although most customers choose five-year durations, other lenders provide fixed-rate mortgages with terms ranging from six months to ten years. The shorter the duration, the better the interest rate. Choosing a longer term means you are effectively purchasing certainty but at the expense of lower interest rates.
What is a variable-rate mortgage?
In contrast, variable-rate mortgage changes based on your financial institution’s prime rate. The prime rate is primarily determined by the Bank of Canada’s key interest rate. Variable-rate mortgages are changed monthly to account for these swings. It is an intriguing option if you want to benefit from a reduced rate from the start as well as prospective rate drops over your term. In the case of rate rises, your budget can withstand an increase in monthly payments or a reduction in principal owed.
As an example, let us assume you had a mortgage with a prime rate of -0.50%. Your lender’s advertised prime rate is presently 2.50%, so you’ll pay 2% interest. Your interest rate would be 1.75% if the prime rate fell to 2.25%. If the prime rate rises to 2.75%, your interest rate will rise to 2.25%.
The pros and cons of a fixed-rate mortgage
Even though fixed-rate mortgages tend to be more common than variable-rate mortgages, it is critical to weigh the benefits and drawbacks before making a selection.
Pros: the stability of a fixed-rate mortgage implies that the rate will stay constant during the term of the loan. Since the rate stays constant, there is predictability in this type of mortgage that allows you to plan ahead and forecast how long it will take to pay off the mortgage.
Cons: on the other hand a fixed-rate mortgage potentially has higher costs over time. This is because in the result that interest rates drop, it is possible that a fixed rate could end up being more expensive when compared to a variable rate. In addition, there tend to be high fees associated with fixed-rate mortgages that can occur if you break your contract, such as selling your home before the end of the term.
The pros and cons of a variable-rate mortgage
Variable-rate mortgages are inherently appealing to many individuals since the interest rates are cheaper than fixed-rate mortgages. However, rates can change at any time, so it is vital to first weigh the advantages and downsides before deciding on a mortgage.
Pros: Costs might be reduced over time. If interest rates remain constant or decline over your term, a variable-rate mortgage will cost you less in interest than a fixed-rate mortgage. In addition, breaking penalties tend to be minimal when compared to other rates. If you need to break your variable-rate mortgage arrangement, most lenders charge three months’ interest. Lastly, the ability to convert to a fixed-rate mortgage is another benefit of a variable-rate mortgage. Many lenders allow homeowners with variable-rate mortgages to switch to fixed-rate mortgages at any time.
Cons: In contrast, variable-rate mortgages lack stability when compared to fixed rates. If interest rates rise, you may end up paying more than if you had a fixed-rate mortgage.
Another con is that converting may cost you extra money. As mentioned you could switch rates but If you convert to a fixed-rate mortgage, the interest rate will be at the current rate, which may be higher than when you took out your mortgage.
How to choose between a fixed vs variable mortgage
A variety of things might influence your selection when choosing the right mortgage for yourself. Fixed-rate mortgages have traditionally been more popular, although variable-rate mortgages have saved homeowners more money most of the time. Having said that, with higher interest rates, many consumers are gravitating toward variable rates.
If you believe interest rates may rise in the future, adopting fixed rates is an excellent approach to lock in your rates. If you anticipate interest are currently high with the chances that rates will eventually fall, a variable-rate mortgage might save you a lot of money. In addition, if you are inherently conservative and dislike taking chances, a fixed-rate mortgage is probably preferable for you because your interest rate will be the same throughout the term and you will know precisely how long it will take to pay off your mortgage. The spread is the difference between the lowest fixed and variable mortgage rates. Many consumers prefer variable rates when the spread is wide. If the spread is small, it may be worthwhile to lock in a set rate.
You may be discussing with your real estate agent in selling your home throughout the term. If you have to break your mortgage, you will have to pay a penalty. Fixed-rate mortgages often compute the cost based on the amount of interest you would pay over the remaining term, which can be expensive. To get out of a variable-rate mortgage, you generally just have to pay three months’ worth of interest. If you find yourself planning to move in the foreseeable future a variable rate may be the mortgage rate to choose.
