Saturday, 27 June 2015

Fixed Vs. Variable Rate Mortgages

While there are pros and cons to both these mortgage types, I am going to try and dispel any myths or misconceptions surrounding each. It's important to understand the difference when choosing your mortgage so that you are not only getting the best rate possible, but are comfortable with any changes that may come along later.

Fixed Rate Mortgages

With fixed rate mortgages, your lender has committed to keeping your mortgage rate the same throughout the term of your mortgage. This is beneficial because it becomes very easy to predict how much of your payment will go to principal or interest each month. (To see it in action, try this Free Calculator)Another benefit is knowing exactly how much of your mortgage will be paid off when you come up for renewal. The one major drawback to this type of mortgage is that this security usually comes along with a higher prepayment penalty should you decide to pay off your mortgage. This can be a major disadvantage if rates fall because it may cost a significant amount of money to break your mortgage.

This penalty is call the Interest Rate Differential and is calculated using the following formula:

(Your Current % Rate - Your Lender's Current Rate for a term Similar to your Months Remaining)/12 x Your Mortgage Balance Owing x # of Months Remaining in Your Term

I know what you're thinking, it's complicated and sounds expensive, and you're right. It's designed by the lender to ensure that they get paid whether you stick around or go somewhere else with your mortgage. To put it in perspective here's an example using a $200,000 balance and a 3.69% interest rate, with a current similar rate of 2.69% and 36 Months left in the term.

(3.69%-2.69%)/12 * $200,000 * 36 Months = $6000.00!

It will cost you approximately $6000 to get out of a mortgage like this! The worst part is, some lenders may even use different calculations including "Discounted" and "Posted" rates so they can charge even higher penalties. Make sure you have a mortgage professional you can trust to be sure that you are aware of the penalties and terms when selecting a new mortgage or when your current mortgage is up for renewal or a refinance.

There are always exceptions to this prepayment rule, as can often be the case with Portability. Read this article for more info on mortgage portability.

Variable Rate Mortgages

The public seems to have a love-hate relationship with variable rates. Historically speaking a variable rate mortgage will almost always save you money in the long-run, but people are wary of the risk of not knowing where rates might be headed. Along with this risk go some major benefits though in the way of prepayment charges. Variable rate mortgages generally use a rule of 3 months interest as the penalty to break your mortgage term. If we go back to the same numbers as our example above, you can see the difference is massive:

(3.69%/12) * $200,000 * 3 Months = $1845.00

That's a potential savings of $4155.00 should you choose to pay off your mortgage early or move to another lender. This can be a huge benefit if rates drop or if something changes in your life that requires a refinance, sale of your property, upsize/downsize, or any major change to your current mortgage.

And The Winner Is.....

There is no clear winner when it comes to Fixed vs. Variable rates, what really matters is the risk you are comfortable tolerating, vs. the potential costs should there be a need to change your mortgage for some reason. When it comes right down to it, if the thought of rates creeping up is enough to keep you awake at night, then a Fixed Rate is the right choice for you. If, however you want prepayment flexibility the the potential to save some money over the term of your mortgage, then a Variable Rate is the better choice.

Everyone is unique, and so too should be your mortgage solution.

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