Often times when arranging a new mortgage a client will ask or be asked; fixed or variable rate mortgage (VRM)? The answer to that is really dependent on a few different factors, and while a variable mortgage may be good for one client, the exact same scenario may be opposite for another. So what exactly are the differences between the two and how can you decide what is best for you? Here are a few points that may help you understand better:
How they work:
The obvious answer is in the names themselves; one rate is fixed and one is variable, meaning that a variable rate mortgage can fluctuate over your term. What exactly is the variable? The variable that you are given is your variance to the prime rate, which will be locked in over your term. For example, your VRM today would look something like Prime -0.25%. Prime today is at 2.70%, which means your rate today would be a NET 2.45%. The variance you are given when you sign up for your mortgage does not change over your term, similar to a fixed mortgage it is locked in. What changes would be your NET rate as it relates to PRIME, which can fluctuate. If prime were to rise by 25 bps or 0.25% up to 3.05%, then your new rate would be 2.80% (3.05% less 0.25%). As prime changes so does your rate, which means your payment and amount paid toward principal changes as well.
A variable rate mortgage is a little bit more flexible than its fixed counterpart. If you were to break your mortgage prior to expiry, your penalty while on a VRM would likely only be 3 months interest. On a fixed rate, your penalty would be the greater of 3 months interest and interest rate differential (IRD), which can get quite pricey if you are only a couple of years into your mortgage.
Who Should Consider a Variable Mortgage?
Someone who is considering going with a variable rate mortgage is typically more comfortable with a bit of risk and the possibility of fluctuation payments. Also, as explained above with the different penalty types, if you are planning to sell your home or pay it off in full within the next couple of years, then you may want to consider a VRM to get that flexibility when it comes time to break it. A client who has a very fixed budget and income would not likely benefit from going with a VRM mortgage, as the possibility of changing rates can throw a wrench into budgets and plans. In today’s lending market, fixed rates are not much higher than the variable at all. So in a case where a client is financing a family home and intends to live there for the foreseeable future, they may be better to take advantage of the low fixed rates and lock in.
Is the Mortgage Process Different? Are There Added Closing Costs?
The closing costs will be the same whether you are getting a fixed rate or a variable rate mortgage, there are no added fees or extra steps in selecting a VRM. The only real difference in the application process comes in qualifying your deal, or in other words, the income used to support your payments. Due to the volatile nature of a VRM, lenders need to ensure you can handle the payments should rates increase. To do this, they will use a qualifying rate from the Bank of Canada as the interest rate when calculating the payments and see if your income is able to support the payments at that level. This gives a buffer in case rates go up. For example, a VRM would be around 2.45% right now, but you would be qualified using a rate of 4.64%. This does not mean you need to pay 4.64% on your mortgage it is only used during qualification.
Benefits vs a Fixed Mortgage:
Again, this depends on some of the factors listed above. But using today’s market, a VRM is less than a fixed rate mortgage right now by a little bit. This means that you would be paying more towards your principal and less towards interest on your monthly payments. However, should prime rate increase you could end up on the other end of the scenario.
Hopefully this helps you to better understand what a variable rate mortgage is and if it is right for you. As always, when seeking a mortgage you should ask all the right questions and have your broker explain all these things to you. If you think a variable rate may be beneficial to you then ask your broker to compare the two over a 5 year term and make an informed decision.
That is basically the ins and outs of buying a home for the first time. There are different ways to make sure you are taking full advantage of these programs and proper ways to apply for them. Make sure you discuss this with your mortgage broker or real estate lawyer so you get what you are entitled to.
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