About 70% of all mortgage holders across Canada currently have a fixed mortgage rate. But that’s not because it’s the best choice – it’s often because it’s the safest option. Historically, variable-rate mortgages have proven to save borrowers the most money over time as part of a longer-term mortgage strategy. So it makes sense to explore this option.
A variable-rate mortgage fluctuates with the lender’s prime rate throughout your mortgage term. So, while your variable-mortgage payment will remain the same throughout your term, your interest rate may change based on market conditions. If the prime rate rises or falls, this impacts the amount of principal you pay off each month. When rates on variable mortgages drop, more of your payment is applied to your principal balance. And, conversely, if rates increase, more of your payment will go towards the interest portion of your mortgage.
It’s important to differentiate between the words ‘term’ and ‘amortization’. The ‘term’ refers to the duration of your current rate, whereas your ‘amortization’ is the length of time it will take to completely pay off your mortgage.
Popular Variable-Mortgage Terms
The most popular variable-mortgage terms are 3 year and 5 year, although they’re available in all increments from 1 to 5 years, with some lenders offering longer terms as well.
Much like the 5-year fixed-rate term popularity, the 5-year variable option is most common among Canadians. Those who aren’t sure they’ll remain in their current home for 5 years are most likely to select a 3-year variable term.
Variable-rate mortgages appeal to homebuyers who are looking to save money throughout the term of their mortgage, and are willing to take on the risks associated with fluctuations in rates over time.
If you’re typically more conservative, yet you happen to be buying a home or renewing your mortgage term during a falling rate environment, this would be a terrific opportunity to try out a variable-rate term. Speak with one of our experts today to help decide what’s best for you.
Open vs Closed Mortgages
An open mortgage offers the flexibility of being able to prepay any amount of your mortgage at any time without facing a prepayment penalty. The compromise for having an open mortgage, however, is that interest rates are higher to make up for the option of being able to pay it off at any time.
With a closed mortgage, on the other hand, the interest rate is more attractive than an open mortgage because you’re limited by how much extra you can pay towards your mortgage each year. So, the compromise here is that you’ll face a prepayment limit. This means that you’re only permitted to pay a certain percentage of your original or current balance per year – often 15%, on average, but this varies between lenders. If you have the choice, be sure to always opt for the original balance prepayment option as it will enable you to pay off more in a year. And if you choose to pay more than your annual limit, you’ll receive a prepayment penalty. It’s important, therefore, to be aware of your limits and stay within them.
What Drives Changes in Variable-Mortgage Rates?
A variable-rate mortgage fluctuates with the lender’s prime rate – which often mirrors movement in the Bank of Canada’s key interest rate – throughout your mortgage term.
Two key benefits of having a variable-rate mortgage, therefore, is that:
- If rates fall, more of your payment goes directly towards paying off the principal amount of your mortgage. In other words, you’ll pay less interest on your mortgage throughout your term.
- It’s cheaper to break a variable-rate mortgage – three months’ interest payment vs an interest rate differential (IRD) penalty often associated with breaking a fixed-rate mortgage.
It’s interesting to note that many banks promote fixed rates because that’s where they earn their biggest profits. This is also why many borrowers are most familiar with fixed rates – and the 5 year term, in particular – as it’s what they’ve been accustomed to hearing about from the banks.