Step 1: Know what you need and want in a mortgage

-Table of contents

Step 1: Know what you need and want in a mortgage

Interest rates: fixed, variable or hybrid

When you apply for a mortgage, lenders may offer you options with either fixed or variable interest rates. Some lenders also offer a “hybrid” option that combines fixed and variable portions in the same mortgage.

Note: The interest rate option (fixed, variable or hybrid) is decided separately from the mortgage type (open or closed) described in the previous section.

Fixed interest rate mortgages

  • You will know in advance the amount of interest you will have to pay (assuming you don’t make any prepayments), and therefore how much of the original loan amount will be paid off during the term.
  • The interest rate is set or “fixed” when you apply for a mortgage. This interest rate remains the same for the entire term.
  • The amount of your regular mortgage payments is also fixed.

Variable interest rate mortgages

  • The interest rate can increase or decrease during the term. The interest rate varies with changes in market interest rates.
  • How changes in the interest rate affect your payments will depend on whether your payments are fixed or adjustable:  

    Fixed payments  

    You pay one set amount with each payment.  

    If the interest rate goes down, more of the payment applies to the principal and you will pay off your mortgage faster.

    If the interest rate goes up, more of the payment applies to interest, and less to the principal. Your lender may require you to increase your payments so that your mortgage will be paid off within the amortization period you had originally agreed to in your mortgage agreement.

    With fixed payments, you don’t know in advance how much of the principal will be paid off at the end of the term.  

    Adjustable payments  

    Your payment amount changes if the interest rate changes. A set amount of each payment is applied to the principal, and the interest portion fluctuates depending on changes to the interest rate.

    If the interest rate goes down, your payments will decrease.

    If the interest rate rises, your payments also increase. This can make it more difficult to plan your mortgage payments over the term of the agreement, so you need to be sure you can adjust your budget to make higher payments.

    With adjustable payments, the amortization period stays the same. You can tell in advance how much of the mortgage will be paid off at the end of the term, because you pay whatever amount is needed to add up to the agreed amount.

Hybrid mortgages

  • Some lenders offer “hybrid” or combination mortgages—part of the mortgage is financed at a fixed rate and part is financed at a variable rate.
  • The fixed portion gives you partial protection in case interest rates go up, and the variable portion provides partial benefits if rates fall.
  • The portions may have different terms. For example, a hybrid mortgage may include a two-year term for the variable portion and a three-year term for the fixed portion.
  • Hybrid mortgages that include portions with different terms may be difficult to transfer to another lender.

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. This may make variable interest rate mortgages attractive in the short term.

However, whether you are better off with a variable interest rate mortgage 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 to predict. For example, between 2000 and 2012, the Bank of Canada Bank Rate, which impacts mortgage rates, varied from 0.5% to 6.0%.

For more information on current interest rates, visit the Bank of Canada’s website at www.bankofcanada.ca or your lender’s website.

Interest rates from 2000 to 2009

Source: Bank of Canada, Bank Rate

Example: Fixed rate compared to variable rate mortgage

Samantha is buying a new home and requires a $200,000 mortgage. She is trying to decide between a fixed rate and a variable rate mortgage.
  • Samantha has chosen a 25-year amortization period, with the goal of being mortgage-free as soon as possible.
  • She decides to get a five-year term.
  • The lowest fixed interest rate she is offered is 4.0%, with a payment of $1,052 every month.
  • The current variable rate she can get is 3.5%, with a payment initially set at $999 every month.

The lender uses adjustable payments for its variable rate option and explains to Samantha that her payments could go up and down with the interest rates. If Samantha decides to go with a variable interest rate with adjustable payments, she will need to budget for the possibility that her mortgage payments may increase.

To help her decide if getting a variable interest rate is right for her, she looked at the following scenarios.

Comparing fixed or variable interest rate mortgages as interest rates rise
 
Scenario 1:
  • fixed interest rate mortgage
  • interest rate not affected by changes in market interest rates
Scenario 2:
  • variable interest rate mortgage
  • interest rate  increases by 2% during 5-year term
Scenario 3:
  • variable interest rate mortgage
  • interest rate increases by 4% during 5-year term
  Interest rate Monthly payment Interest rate Monthly payment Interest rate Monthly payment
Year 1: 4.0% $1,052 3.5% $999 3.5% $999
Year 2: 4.0% $1,052 4.0% $1,050 4.5% $1,103
Year 3: 4.0% $1,052 4.5% $1,101 5.5% $1,209
Year 4: 4.0% $1,052 5.0% $1,152 6.5% $1,316
Year 5: 4.0% $1,052 5.5% $1,202 7.5% $1,423
Over 5-year term
Total payment $63,122 $66,044 $72,607
Interest paid (as part of total payment) $37,230 $41,620 $50,830
Outstanding balance after 5 years
  $174,108 $175,576 $178,223

Over the life of the 5-year term:

  • Scenario 1: Samantha’s payments would remain the same at $1,052.
  • Scenario 2: Her payments would increase by $203 (from $999 to $1,202).
  • Scenario 3: Her payments would increase by $424 (from $999 to $1,423).

Samantha will have to consider whether she is comfortable with the possibility of interest rates increasing and if her budget could handle higher payments. If not, a fixed rate mortgage term may be in her best interest.

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 that 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 require you to pay charge for the mortgage conversion, certain conditions apply—check with the lender.

Remember 

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

A fixed interest rate mortgage may be better for you if: A variable interest rate mortgage may be better for you if:
  • you want to know that your interest rate and the amount of your regular payments are not going to change over the term of your mortgage
  • you prefer knowing in advance how much of your mortgage will be paid off at the end of your term
  • you think there is a good chance that market interest rates will rise over the term of your mortgage.
  • you are comfortable with the possibility that:
    • your mortgage payments could increase (if you have adjustable payments)
    • your amortization period could increase, meaning you would have to make additional payments (if the amount of your payments is set and interest rates rise)
    • you could pay more in interest over the term of your mortgage than you would have paid with a fixed interest rate
  • you think there is a good chance of interest rates staying the same or dropping over the term
  • you follow interest rates closely, which can be important if your mortgage has a convertibility option.
 
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