Fixed and Variable Interest Rates
As a borrower, choosing between a fixed and variable rate mortgage is one of the most important and difficult choices to make in setting up the mortgage. While expert advice is highly recommended, understanding the difference between the two and how they will affect you will help you in making the right decision.
Variable Rates: Higher Risk, Lower Interest?
Variable interest rates are tied to the prime rate, usually set as a percentage above or below prime. This means that as the prime rate goes up or down, so too does your interest rate - and in some cases your payment with it.
Clearly this is an advantage when interest rates are low or dropping: the lower the prime rate goes, the less interest accumulates on your loan, and the smaller your monthly payment. If rates rise, however, then you are responsible for maintaining correspondingly higher monthly payments, and can count on more interest being added to your principal.
Lenders are also trying to predict which way the wind will blow, and set their variable interest rates accordingly. As such, the variable rate offered for a shorter term - say six months or a year - could be very different from the five-year rate, based on best predictions of what will happen to the prime rate.
It is worth noting that there is no cap on how high the prime rate can go; historically, Canada's prime rate has gone up as high as 20%, and that was just a couple of decades ago. By the same token, 2009 has seen the prime rate drop to unprecendented lows. Those choosing variable rates must be prepared for either extreme.
Fixed Rates: Stability at a Price
A fixed interest rate, on the other hand, is one that remains the same for the entire agreed-upon term between you and your lender. No matter what happens to interest rates after you lock in, your lender guarantees you a certain interest rate until your term lapses or you pay out your mortgage. This also means your monthly payments remain stable and predictable for that term.
Predictability can come at a cost, however. If rates drop after you lock in, you must keep paying the higher rate. Conversely, if rates soar, you continue to enjoy the lower rate.
As with variable rates, fixed interest rates offered by lenders will vary depending on the term.
Evaluating Your Own Situation
Clearly, no one can safely forecast the future to make the perfect choice - so how to choose between the two?
The first thing you must assess when deciding is your own risk aversion. Are you comfortable with the idea of a monthly payment that changes, or do you prefer to know what are dealing with, even if you pay a little more for it?
Secondly, you need to evaluate your monthly budget. Is it flexible enough to accommodate higher payments? Is there any danger of not being able to make your mortgage payments if rates go up?
Your mortgage specialist can help you clarify all of these details, and outline the potential risks and benefits of both options.
Between the Horns of the Dilemma
There is, however, a third option - combination mortgage. Also known as the blended or hybrid mortgage, this involves dividing your mortgage loan into both fixed and variable interest rates. The combination mortgage is gaining in popularity, because it allows you to customize exactly how much risk you are willing to take. Much like diversifying your stock portfolio, this can allow you to ride out dramatic changes and benefit from a number of scenarios.