Written by Penelope Graham
Monday, March 18th, 2019
You've made the decision to purchase a home. There are many things to consider at this stage, from picking a neighbourhood that fits your lifestyle, to partnering with the right real estate agent.
It's also time to decide what type of mortgage you'll take out to finance your home purchase. In Canada, there are two main types of mortgage rates and mortgage terms: fixed and variable, and open and closed. There are benefits and downsides associated with each, and your choice can impact the amount of interest you'll pay over the life of your mortgage.
It's important to keep your personal financial situation and risk tolerance in mind when picking your rate and term type. Here's a lowdown on the basics.
Fixed Mortgage Rates: Predictable, But Pricier
With a fixed mortgage rate, the interest rate and payments will not change until the term comes up for renewal, even if interest rates in the market change. This is also referred to as "locking in," and for this reason, fixed rate mortgages offer financial stability, making them a great option for those who want predictable monthly payments.
Because of the stability they offer, fixed mortgage rates are the most popular among Canadians. A total of 68% of borrowers who purchased a home in 2018 chose one, according the year-end Annual State of the Residential Mortgage Market in Canada report issued by Mortgage Professionals Canada (MPC).
Variable Mortgage Rates: Higher Risk, But Historically Cheaper
Variable interest rates are exposed to fluctuations in the market. Prime interest rates are influenced by changes in the overnight lending rate set by the Bank of Canada. This means borrowers may see their monthly payments — or the share of payment that goes toward their principal balance — rise and fall over the course of their mortgage term.
For variable rate mortgages with a set payment, if the prime rate decreases, more of the payment will go towards the principal balance and if the prime rate increases, more of the payment will go towards interest, impacting the time it will take to repay your mortgage in full. If interest rates rise such that the payment is not sufficient to cover the interest on the mortgage, the unpaid interest may be added to the principal amount and the mortgage lender may take other action.
For variable rate mortgages with an adjustable payment, the payment amount will change when there is a change in your lender's prime rate.
As a result, it's important to consider your risk tolerance when choosing a variable rate. Could your budget withstand higher mortgage payments in a rising rate environment? From a historical perspective, variable mortgage rates cost less in interest over the course of a mortgage's amortization, and are generally priced lower than their fixed counterparts. According to the MPC report, the average difference between a fixed and variable mortgage rate in 2018 was 0.55%, representing an $85-per-month difference in payments.
What are Open and Closed Mortgage Terms?
Once you've determined whether you're going with a fixed or variable mortgage rate, you'll need to decide between an open or closed term.
Closed mortgage terms are the most common, though they offer less flexibility. The borrower can't pay off their mortgage before the term is up without incurring a prepayment charge. For fixed rate mortgages, the prepayment charge is usually the higher of three months' worth of interest and an Interest Rate Differential amount. For variable rate mortgages, the prepayment charge is usually three months' worth of interest.
This can make it a less ideal solution for a buyer who knows they'll need to move before their term is up (if their mortgage can't be ported from one property to another), or in the case of job loss or other unforeseen situation in which the home must be sold. However, closed mortgage terms tend to have lower rates.
An open mortgage term offers borrowers the greater flexibility – it can be paid off any time without incurring a prepayment charge (although the lender may have other fees). While open terms come at higher interest rates, and are often limited to variable rate mortgages, they can be a great option for people who know they'll need to move in the foreseeable future, or perhaps even inherit funds to pay off their home purchase.