Canadian mortgage holders and new home buyers have enjoyed a long period of low interest rates. The experts anticipate that rates are likely to rise, not in a dramatic way, but in small increments over the next year and a half. Naturally, homeowners with variable-rate mortgages will want to know if they should lock into a fixed rate. Whether to go fixed or variable is one of the most common questions mortgage brokers are asked. To answer that question, let's take a look at interest rates in general.
There are two different types of interest rates: the Prime interest rate and fixed rates (or long-term rates). The Prime interest rate, which the Bank of Canada (BoC) controls, is what gives us our variable interest rate. The focus of the BoC is on stimulating the economy and keeping the inflation rate low. The best way to stimulate the economy is to get people to spend money, thus, the low interest rate. Now that the economy is nearing full recovery, inflation can become an issue, so to keep it in check the BoC may start to raise the prime interest rate. This is the rate the banks pay to borrow money.
Fixed rates, on the other hand, are based on the bond markets and although what the BoC does with the prime rate has an impact on the fixed rates, the two act independently of each other. The Bond market, like all markets fluctuates daily.
Most homeowners choose a fixed rate because they know exactly how much principal and interest they pay on each regular mortgage payment throughout the term. However, when interest rates go down, they can't take advantage of that to save money on interest payments.
Variable rates are the most popular choice among homeowners between the ages of 35 and 44 according to a recent report from Canadian Association of Accredited Mortgage Professional (CAAMP). While there is always a risk that interest rates will fluctuate, there are other factors to consider. The greatest advantage is the long-term savings on interest costs.
While it's true that variable rates may be increasing over the next 18 months, let's crunch some numbers. For illustrative purposes only, let's assume the rate at which PRIME is increasing to 6% over the next five years. A first-time homebuyer purchases a home with a $300,000 conventional mortgage with a variable rate mortgage of prime minus .50% with a 35-year amortization. And let's assume a fixed rate of 4.5%. On a five-year fixed rate mortgage term, monthly payments are approx. $1412.05. With the variable rate mortgage, payments are $954.78. Making everything equal, let's increase the monthly payment on the variable rate to match the fixed rate payments.
The difference between $1,412.05 and $954.78 is $457.27 at the beginning of the term. This difference is applied right to the principal balance. By the end of the five-year term, assuming Prime increases 0.25% every quarter for 5 years to 6%, the variable rate borrower reduced their principal balance by an additional $16,608.17.
So, should you take the variable or the fixed rate? Once again, it all depends on how well you sleep at night. If you can't because you're worried about the risks of a variable mortgage, then a fixed rate is best for you.
Source: Crystal Lau, Mortgage Consultant, The Mortgage Group