Whether it's your very first home or whether you've landed your dream home, the option of a fixed rate vs variable rate mortgage eventually comes up when it's time to sign papers. While the difference between the two types of mortgages isn't too difficult to understand, it can be surprisingly challenging in the moment to determine which option is right for you. Let's explore these two types of mortgages and look at how to choose which option might be right for you.
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Fixed Rate Mortgages
A fixed rate mortgage simply means that the interest rate you are paying on the principal amount borrowed will stay the same over the length of the term you have agreed to. Mortgage terms (which are different than the amortization period) can range anywhere from 6 months to up to 10 years. Most fixed rate terms are 3 to 5 years long though.
With a fixed rate term, you can anticipate your mortgage payment being exactly the same every time. There's no guessing or worrying about whether your payment will be higher than the previous payment. The only thing that will shift over the length of your mortgage term is the ratio of principal to interest within each payment. The front end of your fixed rate term is slanted toward paying more interest than principal while the back end is slanted toward paying off more of the principal amount borrowed. Again, this has no bearing on your payment amount. If you're looking for predictability and consistency, a fixed rate term can be the way to go.
Variable Rate Mortgages
Variable rate mortgages function differently than fixed rate mortgages in that the interest rate fluctuates over the course of the term. The interest rate on a variable rate mortgage is based on prime interest rates. As the prime interest rate rises, so will your mortgage interest rate. If the prime interest rate decreases, your mortgage interest rate will as well.
Variable rate mortgages typically offer a cheaper rate because of the risk associated with them. The difference may be as minimal as 0.5%, but that can be substantial when you consider how much interest you pay on several hundred thousand dollars of borrowed money.
Benefits Of A Fixed Rate Mortgage
Fixed rate mortgages are advantageous for a couple reasons. The biggest win with fixed rate mortgages is consistency. If you're not wanting any surprises with your mortgage payment because of a tight budget, a fixed rate mortgage can be a good option.
Additionally, if mortgage rates are extremely low and you feel confident they are about to climb, perhaps you might want to lock into a fixed rate mortgage with a 5-10 year term. A long mortgage term can come with other risks, but if you are confident you won't be needing to sell and if you feel a particular interest rate is the lowest you might see in a long time, this can be a possible solution for you.
Benefits Of A Variable Rate Mortgage
Variable rate mortgages typically offer the benefit of a lower interest rate because they are subject to the risk of rising down the road. While there is potential for the interest rate on a variable rate mortgage to rise above the fixed rate percentage, the chances are slim. Historically, this is very rare and shouldn't be much of a cause for concern.
Additionally, if interest rates do rise, you are likely to see very little change in your actual mortgage payments. Instead, the ratio of principal to interest payments within your mortgage payment might shift to favour the interest portion of your payment. On the flip side, if interest rates drop, your overall mortgage payment likely won't change substantially. Instead, your payments will favour paying back the principal amount borrowed over the interest portion.
In addition to these benefits, variable rate mortgages also give you the option to lock into a longer term at a certain rate. If you notice prime interest climbing at an alarming rate, you have the option to lock into a fixed rate at that particular interest rate for the remainder of the term.
Which Mortgage Is Right For You?
Statistically, variable rate mortgages have outperformed fixed rate mortgages for the last thirty years or so. However, many people prefer the peace of mind that comes with a fixed rate mortgage. When you're choosing between the two, it's best to know your risk tolerance and decide accordingly. Always do your homework by consulting multiple lenders for quotes and never be scared to sit down with a mortgage professional who can guide you through the process.