Fixed vs. Variable Rates for a Mortgage: Pros and Cons. When should you pick fixed or variable rate?
Since the beginning of the COVID pandemic and the troubles to economies across the world, many governments have reduced their prime rates to help businesses and citizens.
Now, why should we care about the prime rate? The prime rate is the rate that the governments use to lend money to financial institutions in their countries. Then, financial institutions extend this money at the prime rate plus something to end-users: businesses or the population. Thus, you may hear banks saying they can offer you prime plus 1% or plus 2% for your credit. Thus, the prime rate impacts the interest rates for mortgages along with other credits as the prime rate is the backbone for most credits in the respective country.
Here is how the prime rate changed in the USA over the past 40 years. The trend for Canada looks very much similar. You can spot two things:
We are currently enjoying one of the lowest prime rates in recent history.
The prime rate is quite volatile over the long term. Given the mortgage amortization periods span 15-20 years, you should expect that you will see higher and lower interest rates for your mortgage through this period.
The amortization period for a common mortgage can last 15 to 30 years, and the banks are prepared to form a mortgage contract with you for an average term of 3 to 5 years. This means you will have anywhere 3 to 10 separate terms, each with a separate contract. For each contract term, the bank will update your interest rate according to the current prime rate.
Taking into consideration the above, it is important to try to get the best possible rates at any given time. Imagine having a mortgage at 3.25% (current rate in the USA) or 5.5% (2019 rate). If we keep the monthly payments intact, the interest rate can make a big difference in your amortization period and the interest you pay to a bank. Let's say you borrow $300,000 at 5.5% and plan to fully amortize the mortgage over 25 years. Your monthly payment will be $1,842 and you will pay a total of $252,679 in interest. If your average interest rate over the course of amortization is 3.25% and you keep paying $1,842, you would pay off $300,000 in 18.5 years and will pay $107,542 in interest.
There are a few levers at our disposal in regards to trying to achieve lower interests rates through the course of our mortgages:
Paying more each month when rates are the lowest. This way, more money will go each month towards repaying your mortgage and less towards interest. Later, when interest rates are up, you can reduce the monthly payment, but because you paid more of your mortgage principal, your future interest payments are reduced anyway.
Using shorter and longer terms for your mortgages. When rates are low, it makes sense to lock them by getting into a longer-term mortgage. Some banks offer 7-year or even 10-year terms. However, keep in mind that banks also try to reduce their risks, so the rate they will offer for a 10-year mortgage will be higher than the one for 5-years. Still, in times of superlow interest rates, you can see if getting a longer-term mortgage is more beneficial.
Shopping for the best rates. Don't just stick with your current bank. Shop around to always find the best rate. Remember: while it may seem that half-percent in interest rate is not a lot, it may cost you tens of thousands of dollars down the road.
Exiting the contract earlier. Lenders usually put termination penalties into the mortgage contract. There are 2 types of penalties: a fixed amount and the one under which you will pay the difference between the current rate and the rate you were paying to the bank. However, when you have just a year or 2 left in your mortgage, the rates are low, but you believe they will go up very soon - it is sometimes more beneficial to break the current mortgage early and start a new one.
The last lever at our disposal is the types of rates: fixed vs. variable.
What is a fixed-rate mortgage? Fixed-rate mortgage pros and cons.
A fixed-rate mortgage means that the interest rate and the monthly payment do not change throughout the term. For example, given a mortgage of $300,000 at a rate of 3.25% compounded semi-annually, a term of 5 years, and an amortization of 25 years, the monthly payment is $1,461.95.
This monthly payment would remain constant for the full 5 years. At the end of this 5-year term, the outstanding balance would have to be repaid to the current bank either with cash or refinancing with the current or a new lender.
The portion of interest and principal within this constant payment will change every month as the interest payable decreases. Using the example above, we can see below that for the first payment, $812.5 goes towards interest repayment; the rest goes against the actual mortgage loan. For the last payment of the 5-year term (payment 60), $700.14 goes towards paying the interest; the rest is used to repay the loan. Thus, your repayment of the actual loan accelerates with time.
| Payment 1 | Payment 60 (end of 5-year term) |
Mortgage balance (before payment) | $300,000 | 258512 |
Monthly Payment | $1,461.95 | $1,461.95 |
Amount of monthly payment to pay interest | 812.5 | 700.14 |
Amount of monthly payment to repay mortgage | 649.45 | 761.81 |
Mortgage balance (after payment) | 299350.55 | 257750.20 |
Benefits of a fixed-rate mortgage
Security. The main benefit of this type of mortgage repayment plan centers around security. The borrower knows the exact payment he or she will be paying throughout the term of the mortgage and can budget accordingly. This security should not be overlooked in terms of importance, especially for first-time homebuyers who may be used to renting and paying a fixed amount for shelter every month.
Risks of a fixed-rate mortgage
Potential Lack of Savings. There are no basic risks attached to this type of mortgage repayment plan for the borrower. The key risk is the lost opportunity (that may or may not happen) to be locked into the interest rate set in the contract. If the rates have dropped, you would be missing an opportunity to pay less interest and/or repay the mortgage faster.
What is a variable-rate mortgage? Variable-rate mortgage pros and cons.
Under the variable-rate mortgage, your interest is usually defined as prime rate + x% (e.g., prime +1%). The lender would post its rates monthly, and your interest would be adjusted. This type of repayment plan is designed to protect the lender and the borrower from fluctuations in interest rates. For example, if the rates are low today, and you decide to go with a variable-rate mortgage when prime rates increase, your interest will also increase. This is a benefit to a bank. Vice versa, if prime rates decrease, your interest also decreases, which is a benefit to you. Another benefit for the lender is the stability of financial results on their accounting books. If they borrow money from the government and lend it to you, having a variable rate will mean they will constantly receive the same % profit. For this increased security to the lender, the borrower tends to receive a lower rate than on a fixed-rate mortgage.
Below is the difference between fixed and variable rates in Canada for the past few years:
Source: https://blog.cidirectinvesting.com/variable-vs-fixed-mortgage-2/
In this type of variable rate mortgage, the payment remains the same, or constant, while the percentage of the payment allocated to interest and principal fluctuates according to the current interest rate. If the rate goes up, more of the payment is comprised of interest, and vice versa. If the rate was to rise past a certain point, the borrower would not be repaying all of the interest for the period, let alone any principal.
Benefits of a variable-rate mortgage
Savings. For borrowers who are not “risk-sensitive” (fluctuations in rates do not cause them stress), this type of repayment plan can save them money. In most cases, the rate for variable-rate mortgages has been lower than those of fixed-rate mortgages.
Ability to switch to a Fixed Rate. Most variable-rate mortgages offer the flexibility of allowing the borrower to switch to a fixed-rate product through the same lender without penalty. This provides the borrower with the comfort of being able to switch if the variable rate begins to rise.
Good option if you believe rates are about to decrease. Variable rates may be a good option if you believe the rates are about to decrease but are forced into a contract renewal right now. This usually happens during times when the economy is depressed or after a financial crisis. In times of increasing inflation and economic boom, you should expect the rates to increase.
Risks of a variable-rate mortgage
Volatility. This type of mortgage, while being able to save the borrower money, can also have the reverse effect if the lender increases its rates. The borrower must be financially sophisticated enough to keep a close watch on the economy, rates, and decide to switch to a fixed rate product if and when the situation warrants it.
Negative Amortization. If the interest rate rises, the possibility exists that the fixed payment will not be sufficient to cover the interest due for the payment period. This will cause the borrower to potentially enter a negative amortization scenario, forcing him or her to increase his or her mortgage payment or pay a lump sum of money to the lender to return the mortgage to a positive amortization.
Payment Increase. As mentioned, if the borrower falls into the negative amortization, he or she will have to increase the monthly payment. The question then becomes can the borrower afford the higher payment?
To summarize, there are a few levers you can use to try to get the lowest possible interest rates during the amortization period of your mortgage:
Paying more each month when rates are the lowest.
Using shorter and longer terms for your mortgages.
Shopping for the best rates.
Exiting the contract earlier.
Using fixed or variable terms for your mortgage.
Any of the above require you to watch the interest rates available in the market and have a general knowledge of the state of the economy. Alternating fixed and variable rates for your mortgages can be one of the ways to reduce the interest payments as they tend to have better rates compared with fixed rates. However, in times of increasing rates, make sure to know how the increase in the rate will impact the proportion of interest and principal you would be paying and switch to a fixed mortgage if needed.