Mortgages come with a variety of different options, which is great news! Why? Because everyone has unique preferences and needs when it comes to home loans.
Take open and closed mortgages, for example. Open mortgages offer greater flexibility in how and when you pay down your loan. However, you often pay for that added flexibility with a higher mortgage rate.
In comparison, closed home loans often come with better interest rates but more restrictions when it comes to paying off your mortgage before your term ends. That being said, your financial institution may have prepayment options, even for closed mortgages, allowing you to make additional payments to your home loan without penalty. Where fees or penalties may apply is if you want to pay out your entire closed mortgage.
Looking for a lower rate? A closed mortgage may be your best bet. Want to pay down your loan early and aggressively? An open mortgage might be what you're looking for. The better choice for you depends on your financial flexibility and goals.
The same principle applies to a fixed vs variable-rate mortgage. Each has its upsides and downsides. Deciding which is better for you starts with understanding both options. Then, you can choose which option fits your future plans the best.
Let's take a closer look at a fixed and variable-rate mortgage.
What is a Fixed-Rate Mortgage?
A fixed-rate loan provides financial certainty because it has a fixed interest rate. In contrast, a variable-rate mortgage will fluctuate based on the prime interest rate in Canada.
As Forbes explains, each financial institution sets its prime interest rate. However, the terms generally align with guidance from the Bank of Canada.
With a fixed-rate mortgage, your interest rate is locked in for the mortgage term. It won't increase or decrease with changes in the national or global economy, making your monthly mortgage payments much more predictable. Each payment goes directly toward a set amount of principal and interest. It’s, therefore, much easier to manage your budget without the worry of potential cost increases.
In recent years, rising interest rates have made locking in a fixed rate an appealing choice for many borrowers seeking financial stability. However, if interest rates were to drop and stay low, a fixed-rate home loan could end up being the more costly option out of the two.
How Does a Fixed-Rate Mortgage Work?
Essentially, a fixed-rate mortgage locks in the interest rate you’ll be charged on the loan for its entire term, regardless of the potential swings in the market. Your monthly mortgage payments will stay the same over your entire term, whether it’s six months, three years, or longer.
In general, if the current interest rates in the market are relatively low but expected to rise, it’s better to lock in your home loan to avoid incurring extra costs. Note that while this option grants more financial security, it comes at the expense of missing out on potential savings if market rates drop.
Most borrowers looking to purchase a home opt for a fixed-rate plan due to its predictability and reduced exposure to risk.
Fixed-Rate Mortgage Types
When deciding on which type of fixed-rate mortgage to go for, consider the differences between closed and open mortgages:
Closed mortgage. A closed mortgage is the most popular option that often comes with lower interest rates. At the same time, closed mortgages provide limited opportunities to repay a home loan early. Check with your financial institution regarding prepayment options. (At Innovation, you can pay up to 20% of your original mortgage principal each year in addition to increasing your scheduled payments by 20% without penalty.) However, breaking a closed mortgage agreement before the term’s end might leave you with prepayment penalties.
Open mortgage. This option allows you to pay off your entire home loan ahead of time with no penalties. However, such flexibility means higher interest rates compared to closed mortgages.
Fixed-Rate Mortgages: Pros and Cons
Advantages of a fixed-rate mortgage:
Stability. Your interest rate is locked in for the life of the loan. This ensures it won’t fluctuate due to changes in the prime interest rate or other market factors.
Simplicity. Fixed-rate mortgages are straightforward to understand, which makes them a great option for first-time homebuyers or those who value a clear, unchanging loan structure. You won’t need to monitor interest rate trends or worry about refinancing as rates change.
Use a mortgage calculator to estimate the overall cost of your fixed-rate home loan.
Disadvantages of a fixed-rate mortgage:
Potential higher interest rates. Locking in an interest rate offers stability. However, it also means you won't secure the lowest rate available.
Limited flexibility. Fixed-rate mortgages typically have less flexibility if you want to pay off your loan early or refinance to take advantage of lower rates. Some lenders impose penalties for breaking the loan term before it matures.
What is a Variable-Rate Mortgage?
A variable-rate home loan doesn’t have a rate that is locked in for the mortgage term. Instead, the rate changes based on the prime interest rate.
This might mean paying more or less compared to a fixed-rate option. With consistently low interest rates, you can save money. On the other hand, if interest rates keep rising, you'll have to pay more than you would with a fixed-rate mortgage. It's crucial to track rate changes and consider how they might affect your payments.
All else being equal, a variable-rate mortgage typically comes with a lower starting interest rate because it carries extra risks. In contrast, those who opt for a fixed-rate mortgage pay a premium to secure a stable rate and eliminate risk exposure. While potential gains might be enticing, it’s always a good idea to ask an advisor for their expert opinion on whether the benefits of a variable-rate home loan outweigh the risks.
How Do Variable Mortgage Rates Work?
Unlike a fixed-rate home loan, a variable-rate loan doesn’t come with the same degree of predictability. Your interest rates aren’t locked in and instead, follow prime rate fluctuations. This may mean uncertainty about the amount of your next monthly mortgage payment, depending on the payment structure you choose.
The Bank of Canada explains that variable-rate mortgages have two types of payment structures. A variable payment structure will change along with the prime rate. That means your mortgage payments will increase or decrease in step with the prime interest rate, making your payments unpredictable.
A fixed payment structure stays the same each month despite changes in the prime interest rate. However, the amount of money that goes toward your mortgage interest and principal will change. A higher prime rate will result in it taking longer to pay off the principal of your loan, costing you more money.
Even with fixed payments, your monthly payment may increase. If the prime rate rises so much that your mortgage payment no longer covers your accrued interest, you’ll need to pay more. Sadly, in this instance, none of your payments will go toward your principal loan amount.
The best possible scenario is that rates stay unchanged or potentially decrease over the lifespan of your loan. While this option might seem more appealing to you for the cost-saving potential, it exposes you to the unpredictable forces of the market.
Variable-Rate Mortgage Types
Like fixed-rate home loans, variable-rate mortgages can be closed or open. But with a variable-rate mortgage, you can also choose between fixed and variable payment structures:
Closed vs open mortgage. As with a fixed-rate mortgage, a closed mortgage offers the advantage of lower interest rates compared to an open mortgage. However, it doesn’t allow you to repay your home loan before the set term. Doing so leads to prepayment penalties. Open mortgages, on the other hand, grant the flexibility to repay the loan earlier at the expense of higher interest rates.
Fixed payment structure vs variable payment structure. As mentioned above, with a fixed payment structure, your monthly payments remain the same for small prime interest changes. If the rates decrease, a greater portion of your payment goes towards the principal. Conversely, if the rates move up, more of your payment goes toward interest. If the rate increases too much, your fixed payment will increase, and your entire payment will go towards paying your accrued interest.
In contrast, a variable payment structure adjusts your monthly payments directly with interest rate changes. Payments decrease when rates drop, but they rise when rates increase, making budgeting less predictable.
Variable-Rate Mortgages: Pros and Cons
Advantages of a variable-rate mortgage:
Lower rates. By taking on additional risk, you can potentially access lower interest rates.
Opportunities for savings. If interest rates stay low or decrease, you could pay less overall compared to a fixed-rate mortgage.
Reduced penalties. Want to break your loan? It's usually less costly with a variable-rate home loan.
Disadvantages of a variable-rate mortgage:
No certainty. Predicting economic fluctuations can be challenging, leaving your future interest rate unknown,
Potentially higher costs. If interest rates rise and stay high, your home loan could become significantly more expensive.
Get the mortgage that works for you!
Variable-Rate Mortgage vs Fixed-Rate Mortgage
Whether you’re looking to secure your first mortgage or to renew your mortgage, the following table can help you explore the fundamental differences between fixed and variable-rate mortgages.
Let’s Compare | Fixed-Rate Mortgage | Variable-Rate Mortgage |
Predictability | High due to locked-in interest rates that remain unchanged throughout the mortgage term | Low due to potential market fluctuations and changes in prime interest rates |
Financial stability | Greater stability due to locked-in interest rates | Lower stability due to reliance on prime rate |
Interest rates | Higher | Lower |
Monthly payments | Remain the same during the loan term | Change based on the prime interest rate (note that with a fixed payment structure, monthly payments might stay the same but allocated to the principal and interest differently based on the market trends) |
Overall loan cost | Predefined by a set interest rate | Could be lower than with a fixed-rate option if the prime rate drops or higher if it increases |
Risk exposure for the borrower | Low | High due to potential market volatility |
Penalties | Higher penalties if the borrower breaks a closed, fixed-rate loan | Low-to-no penalties when paying off a loan early |
Budget planning | Easy budget planning due to stable rates and predictable payments | More complex planning to account for different scenarios, i.e., rate increases and decreases |
Types | Open and closed | Open and closed, fixed and variable payment structure |
The Bottom Line
When it comes to securing funds to buy a new home, there’s no perfect option. You may prefer stability and security in which case a fixed-rate mortgage is the right choice for you. Conversely, lower starting interest rates with the potential to decrease loan costs over time may sound more appealing. Here, a variable-rate loan is the best option.
Knowing the risks and benefits of each mortgage type is crucial to making a well-informed decision. Get a free mortgage transfer eBook to learn which kind of home loan matches your goals, or contact us for help today!