Variable vs. Fixed - The various types of mortgages available to you.

As I am sure you have heard, interest rates are on the rise.  Variable vs Fixed is now the question at hand.  For those who are putting less than 20% down payment, the Bank of Canada implemented last year new rules regarding variable and fixed term mortgages less than 5 years with a "stress test", which essentially means, will you be able to pay your monthly mortgage if the rates increase by roughly 2%?   

I digress...Without getting into the logistics of the Bank of Canada and their lending rules, the question we have here is - variable vs. fixed and which is better.   Let's imagine you are approved for both.

fixed vs variable.jpg

The "pros" of variable interest is it saves you money overall.  History has shown that even when fixed rates are lower than variable, in the long run, variable wins.  The cons of variable is that your interest rate fluctuates with the prime rate of your bank.  If the Bank of Canada raises its overnight rate, then the banks follow suit with raising the prime lending rate and that means your monthly payment has gone up.  

Graph of prime lending rate canada.jpg

With a fixed mortgage, your monthly payment stays the same, regardless if the rates have gone up.   This type of mortgage is good for those who want less anxiety and want stability.  However, in the long run, it is more expensive.  Historically speaking...

Just as there are many different lending institutions, there are almost as many different varieties of mortgages available. This is another good reason to consult a mortgage broker. Depending on your situation, one type of mortgage may be better for your circumstance than another.

Conventional Mortgage

If you have at least 20% of the purchase price (or appraised value if this is lower than the purchase price) as a down payment, you can apply for a conventional mortgage. Some lenders will require CMHC insurance because of the property’s location or type, even though you have 20% or more equity.

High-Ratio Mortgage

If you have between 5% and 19.99% of the purchase price as your down payment, you can apply for a high-ratio mortgage. Usually these must be insured through CMHC (Canada Mortgage and Housing Corporation), Genworth Financial and Canada Guaranty. These are mortgage insurance companies that covers the lender in case of default. Purchasing insurance is a common way of qualifying for a mortgage when you have less than 20% equity. The insurance premium is charged only once (per mortgage), when the mortgage funds are advanced. You can pay the premium yourself, but most people choose to add the funds on top of the mortgage.

Open Mortgages

An open mortgage allows you to pay off part or the entire mortgage at any time without penalties. Open mortgages usually have short terms of six months or one year. The interest rates are higher than those for closed mortgages with similar terms.

Variable Rate Mortgages/ Adjustable Rate Mortgages

At the start of a variable rate mortgage, the lender will calculate a mortgage payment that includes principal & interest. For the term of the mortgage your payments usually do not change. However, as the prime rate changes so will your mortgage rate. If interest rates are dropping, less money will go towards interest and more will go towards principal. If interest rates rise, more of your payment will be interest and less money will be reducing your principal.

Some of these mortgages are completely open (you can pay off all or part of your mortgage at any time without penalties). Others that offer a ‘prime minus’ interest rate (e.g. prime - 0.375%) may charge a penalty. The interest rate on most variable rate mortgages is compounded monthly.

Capped Rate Mortgages

These are variable rate mortgages that the lending institution has  ‘capped’ the interest rate. In other words, the rate will fluctuate with prime, but the institution guarantees that you will not pay more than a certain interest rate, set by them. These mortgages often have a penalty for early ‘payment in full’ and are often not portable.

Closed Mortgages / Fixed Rate Mortgages

The expression ‘closed mortgage’ originates from the 1980’s when this type of mortgage was literally ‘closed’. You contracted to the lender to make your payments for the term chosen, you could not pay anything additional, nor could you pay off the entire amount for any reason except the sale of your property. These days, there are many ways to pay down your mortgage principal quicker, though the name ‘closed’ mortgage remains. See pre-payment options for ways to pay off your mortgage quicker.

Fixed rate mortgages are the most popular type of mortgage. You benefit from the security of locking in your mortgage interest rate, for lengths of time ranging from 3 months up to 10 years. The rates are slightly lower than an open mortgage for the same term. If you think interest rates could rise, you may want to choose a longer term, such as a 5 or 10-year term. If you think that rates are going lower, you may want to gamble on a shorter length of time. 

The major lending institutions have different pre-payment options allowed under their contracts. These options allow you to pay off your mortgage faster. It is also possible to pay off most closed mortgages prior to the end of the term or pay down a portion of the balance owing. However, lenders charge penalties for doing so.

Please note that some lending institutions will not give any pre-payment options. It is wise to find out what options are available before entering into any mortgage contract.

Convertible Mortgages

These are fixed rate mortgages for terms of 6 months or 1 year. Not all lending institutions offer convertible mortgages. With a convertible rate mortgage, you can lock into a longer term during the current term of your mortgage without penalty - but only with the same lender. For example, if after a couple of months, you hear that interest rates are going to increase, you may change to a longer-term mortgage such as the 5-year term.

Reverse Mortgages

CHIP - Canadian Home Income Plan is the name of the company providing reverse mortgages in Canada. A reverse mortgage allows homeowners to convert equity in their homes into cash, without selling the property or having to make monthly payments. To qualify, homeowners must be at least 62 years old, have significant equity in their property and live in Ontario. The amount that can be borrowed depends on the homeowner’s age. Reverse mortgages are for between 10% and 40% of the appraised value of the home. The older the homeowners, the more they can borrow.

The homeowner retains ownership and possession of the house. The lending company registers a reverse mortgage against the property. At death, or when the house is sold, the loan and the accrued interest must be repaid.

The biggest disadvantage to reverse mortgages, is that the interest keeps building on the amount of money borrowed (hence the maximum 40% loan). This means that if you borrow $50,000 this year and your interest bill is $5,000, next year your interest will be charged on $55,000 and so on. The longer the loan is in place, the greater the interest bill that must be paid.

It is possible that when the house is sold, 100% of the proceeds from the sale may be required to pay off a loan. If the homeowner dies the estate will have to pay off the loan and the accrued interest. This may wipe out any inheritance for the homeowner’s heirs.

An alternative is to establish an equity credit line. This allows you to take funds only as you need them, thereby owing the least interest possible, with no surprises.


jay vroom