Understanding Fixed and Variable Interest Rates

 

 

What are your options?

When you apply for a mortgage, lenders may offer you options with either fixed or variable interest rates.

Note:   The type of interest rate (fixed or variable) is decided separately from the type (open or closed).

 

Fixed Interest Rate Mortgages

With a fixed interest rate mortgage, the interest rate is determined when you apply for a mortgage. This interest rate is set for the entire term. The amount of your regular mortgage payments is also fixed.

Because the interest rate does not change throughout the term, you know in advance the amount of interest you will have to pay (assuming you do not make any pre-payments), and therefore how much of the original loan amount will be paid off during the term.

 

Variable Interest Rate Mortgages

A variable interest rate mortgage is a mortgage loan with an interest rate that can change during the term. The interest rate varies with changes in market interest rates. Because mortgage payments and interest rates can change, it is impossible to know in advance how much of your original loan will be paid off during your term. However, your mortgage lender will give you an estimate based on the variable rate at the beginning of your mortgage term.

With a variable interest rate mortgage, the amount of the payments can be either

  • fixed, or
  • variable such that the amount of the payment would change when interest rates change

Note:   In this context the fixed and variable comments refer to the amount of payments NOT the interest rate. Because the finance industry is using fixed and variable for both the payment amount and interest rate, this can be very confusing.

It depends on the lender and the terms of the mortgage agreement.

The interest rates on variable rate mortgages are often lower than on fixed interest rate mortgages with the same term length when you sign your mortgage agreement, so variable interest rate mortgages may be attractive in the short term.

However, whether you are better off with a variable interest rate mortgage as compared to a fixed interest rate mortgage depends on whether the market interest rates go up or down during your term. This movement is difficult or at all to predict.

 

Variable interest rate mortgages: impact of interest rate changes

Before signing a variable interest rate mortgage agreement, it is important to understand how interest rate changes can affect you. There are some differences between variable payments and fixed payments.

 

Payment Type

Rising Interest Rates

Declining Interest Rates

Variable Payments

o your payments would increase

o you may have higher payments than if you had chosen a fixed interest rate mortgage

Consider how much of an increase in mortgage payment amounts you could handle. If you do not think you can handle an increase in your mortgage payment due to rising interest rates, or do not have enough future cash flow, you may be better off with a fixed interest rate mortgage

o your payment amount may go down

Check with your lender to see if you can pay down your mortgage faster by maintaining or increasing your payments, or making a lump sum pre-payment.

Fixed Payments

o you would pay less toward your principle than expected and more toward interest, which would lengthen the time needed to pay off the mortgage

o at the end of the term, the mortgage lender may require you to increase your payments so that your mortgage will be paid off within the amortization period that you originally agreed to

o you may pay more in interest than if you had chosen a fixed interest rate mortgage

o you would pay more toward your principal than expected and less towards interest, which would shorten the time needed to pay off your mortgage

o you would pay less in interest with a variable rate mortgage than with a fixed rate mortgage

 

Variable interest rate: how to protect yourself

Some lenders offer interest rate caps or convertibility features on their mortgages. These features can offer some protection if interest rates go up. You can get these features only when you sign a new mortgage agreement.

An interest rate cap is the maximum interest rate than can be charged on a mortgage, regardless of the rise in interest rates.

If your mortgage has a convertibility feature, you can “convert” or change it to a fixed interest rate mortgage during the term. Although the lender will usually not charge a penalty for the mortgage conversion, certain conditions apply.

Note:   The fixed interest rate could be higher when you convert the mortgage than the variable interest rate you had been paying.

 

Making a decision between fixed and variable interest rate mortgages

There are a few factors to consider when choosing between a fixed and variable interest rate mortgage.

Take the time to go through the list in the table and tick off the statements that are congruent to your comfort level, knowledge, and personal financial situation.

 

Fixed interest rate mortgage may be better if:

Variable interest rate mortgage may be better if:

o you want to know your interest rate or the amount of your regular payments is not going to change over the term of your mortgage

o you prefer knowing in advance how much of your mortgage will be paid off at the end of your term

o you think there is a good chance that market interest rates will rise over the term of your mortgage

 

o you can handle an increase in your mortgage payment if interest rates increase

o you are comfortable with the possibility that

o   your mortgage interest rate and payments could increase

o   you could pay more in interest over the term of your mortgage than you would have paid with a fixed interest rate

o you follow interest rates closely

o you think there is a good chance of interest rates staying the same or dropping over the term

 

Please call me for more information and an informal discussion on fixed and variable interest rates.