One of the biggest questions that you have to answer when you buy a home is whether to choose a fixed or variable rate mortgage. As with all things personal finance, you need to figure out which works best for you.
What is a Variable Rate Mortgage?
While variable rate mortgages have been available in the United States for much longer, they have only been widely available in Canada since the 1990s.
These mortgages are those in which the mortgage rate changes periodically. Instead of locking in a rate for the entire term of the loan, the mortgage rate changes with the market rates. In many cases, a variable rate starts out lower than a fixed rate, since there is the potential for the rate to rise over time. This means that your mortgage payment can change several times until you pay it off. A fixed rate ensures that your mortgage payment remains the same throughout the entire term of your loan.
Interestingly, a variable mortgage rate might provide you with a better outcome than a fixed rate. A report released in 2001 states that, historically, variable rate mortgages at prime have benefited borrowers 88.6% of the time over the fixed rate. Obviously borrowers who have rates of less than prime are even better off.
This historical savings is the risk premium; the return in excess of the risk-free rate of return, which is the fixed rate.
But Could a Fixed Rate Be Better Right Now?
Historically, a variable rate has been better overall for Canadian home buyers. This is because at the time of the study, rates were higher relative to now. The market has changed, so if you’re looking for a mortgage right now, it may be one of those few time periods where a fixed rate mortgage may be a better deal than a variable rate, at least over time.
Canadian mortgages are coming with longer terms, influenced by the way things work in the United States. This means that locking in at a low rate now, especially if you have a longer term loan, can help you avoid interest rate increases later.
On the other hand, the Bank of Canada doesn’t show any signs of raising its benchmark soon, and there are worries that the housing market is in a bubble. When you you think about the situation in those terms, it might actually make sense to go with a variable rate mortgage right now, especially if you get a 5 year loan.
Take a look at your individual situation, and run the numbers. Also, consider what you think is likely to happen in the next few years. Will conditions mean that mortgage rates rise before you can do something different with your loan?
Unfortunately, there is no predicting the future, and no sure way to ensure that you are doing what best for your mortgage situation right now. Think about your cash flow, and whether you prefer a fixed payment to a variable payment, and then get the mortgage that works best for you.