Fixed versus variable interest rates
This is usually the more popular choice for clients
when it comes to deciding on which type of interest rate they want.
There are many reasons why, but the most unsurprising answer is always
safety. With a fixed interest rate, you know exactly what you are paying
every month and you know that the amount of interest being charged for
the term of your mortgage will not increase and it will not decrease.
Fixed interest rates can be taken on 1-year, 2-year, 3-year, 5-year, as
well as 7 and 10-year terms. Please note, term is not meant to be
confused with amortization. When you have a 5-year term but a 25-year
amortization- the term is when your mortgage is up for renewal, but it
will still take you the 25 years to pay off the entire debt. The biggest
knock on fixed interest rates when it comes to mortgages, especially
5-year terms, is the potential penalty. If you want to break your
mortgage and pay it out, switch lenders, take advantage of a lower rate,
or anything like this and your term is not over, there will be a
penalty. With a 5-year term, a fixed rate penalty can be anywhere from
$1,000- $20,000 or more. It all depends on the lender’s current rates,
what yours currently is, the length of time remaining on your term, and
the balance outstanding. The formula used is called an IRD (interest
rate differential) and the penalty owed will either be the amount this
formula produces or three month’s interest- which ever is greater. Fixed
interest rates, especially 5-year terms can be the most favorable.
They are safe, competitive interest rates that you will not need to
worry about changing for the term of your mortgage. However, if you do
not have your mortgage for the entire term, it could hurt you.
Variable Rate Interest
The Bank of Canada sets what they call a target
overnight rate and that interest rate influences the prime rate a lender
offers consumers. A variable rate, is either the lender’s prime lending
rate plus or minus another number. For example, let us say someone has a
variable interest rate of prime minus 0.70. If their lender’s prime
lending rate is 5.00% in this example, they have an effective interest
rate of 4.30%. However, if for example the prime rate changed to 6.00%,
the same person’s interest rate would now be 5.30%. Written on a
mortgage, these interest rates would look like P-0.7. Variable interest
rates are usually only available on 5-year terms with some lenders
offering the possibility of taking a 3-year variable interest rate. When
it comes to penalties, variable interest rates are almost always
calculated using 3-months interest, NOT the IRD formula used to
calculate the penalty on a fixed term mortgage. This ends up being
significantly less expensive as breaking a 5-year term mortgage at a
fixed rate of 3.49% with a balance of $500,000 will cost approximately
$15,000. That is if you use the current progression of interest rates
and broke it at the beginning of year 3. A variable interest rate of
Prime Minus 0.5% with prime rate at 3.45% will only cost $3,800. That is
a difference of $11,200. You can expect to pay this kind of amount for
the safety of a fixed rate mortgage over 5-years if you break it early.
Which one is best?
It completely depends on the person. Your loan’s term
(length of time before it either expires or is up for renewal) can be
anywhere from a year to 5 years, or longer. A first-time home buyer
typically has a mortgage term of 5 years. Within those 5 years, the
prime rate could move up or down, but you won’t know by how much or when
until it happens. Recently, variable rates have been lower than fixed
rates, however, they run the risk of changing. With fixed interest
rates, you know exactly what your payments will be and what it will cost
you every month regardless of a lender’s prime rate changing. If you go
to the site www.tradingeconomics.com/canada/bank-lending-rate
you can see the 10-year history of lender’s prime lending rate. Because
lenders usually change their prime lending rate together to match one
another (except for TD), this graph is a good representation. As you can
see, from 2008 to 2018, the interest rate has dropped from 5.75% to
2.25% all the way back up to 3.45%. Canada has had this prime lending
rate since 1960, and in that time it has seen an all-time high of 22.75%
(1981) and all-time low of 2.25% (2010). Whether you want the risk of
variable or the stability of a fixed rate is up to you, but allow this
information to be the basis of your decision based on your own personal
needs.
If you have any questions, contact a Amy Wilson your Dominion Lending Centres
mortgage professional.
Thanks to Ryan Oake for this article
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