Shopping around for a mortgage? You’ll quickly learn there is no one-size-fits-all product available to everybody.

When you start narrowing it down, one of the first decisions you’ll have to make is whether you want a fixed- or variable-rate mortgage. To determine which one suits you best, it’s essential to understand the economy, your lifestyle and tolerance to risk. To help first-time homebuyer’s make the choice, we spoke to Toronto-based mortgage agent Lisa Okun for the advice she gives her clients.

Photo: James Bombales

Let’s start with the basics. What’s the difference between a fixed- and variable-rate mortgage?

With a fixed-rate mortgage, you agree to pay a set interest rate for the predetermined ‘term’ — the length of time you commit to the interest rate, lender and associated conditions of your mortgage product. The most common term length is five years but they can range from six months to 10 years.

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For example, a bank quotes you an interest rate of 3.5 percent for a five-year term, on a $500,000 loan, amortized over 25 years. With a fixed-rate mortgage, you will pay 3.5 percent interest on your monthly mortgage payments until the five-year term is up and you inevitably have to shop around for a new mortgage product — either with your current lender or somewhere else. “Fixed is going to be your rate for the entire term of your mortgage, it’s not going to change at all,” explains Okun.

Variable-rate mortgages are a bit more complicated because your monthly interest rate can fluctuate from month-to-month, based on what’s happening with the economy. Variable mortgages are appealing because historically they lead to more savings over time than a fixed mortgage. The drawback is the risk involved because your monthly mortgage payments can change dramatically without warning.

Variable-rate mortgages are influenced by short-term rates, while fixed-rate mortgages are based on longer-term rates. The central bank looks at a host of economic factors and sets a benchmark interest rate that lenders can offer clients with variable mortgages. This interest rate moves in tandem with the Bank of Canada’s overnight lending rate which changes eight times a year and influences the prime rate. If prime goes down, your interest rate will go down. If prime goes up, you’re paying more that month.

Photo: Jonathan Petersson on Unsplash

With a variable-rate mortgage, you will also get a discount on prime.

In addition to looking at the prime rate, your lender will offer you an additional discount on your interest rate that will be true for the entire term of your mortgage.

“When you get a variable rate, you’re getting a discount,” says Okun. “It could be prime minus 95, prime minus 35, prime minus 1.05, etc. And that discount is true for the life of your mortgage but as prime fluctuates so will your rate.”

At the time of writing, prime is at 3.95 percent. If prime went up to 4.0 percent and you have a discount of 80, you will pay 3.20 percent interest. If prime went down to 3.80 percent, your discount would bring you to three percent.

The discount available to you will vary based on the lender you go with and the mortgage products available to you. Are you putting down less than 20 percent and defaulting to an insured mortgage and CMHC insurance? Are you refinancing your mortgage? Is it for your primary or secondary home? Are you going with a bank or a mortgage agent? All of these factors and more will impact the discounts you have access to.

Photo: James Bombales 

What’s the most popular choice?

The majority of Okun’s clients go for a fixed mortgage.

“Most people are a bit more risk averse, especially first-time homebuyers,” says Okun. “It’s their first time trying it out and they want the stability of knowing that they’re going to have the same payment every month.”

Okun notices that people who are a bit more seasoned are more likely to take a variable mortgage. “People who have had a mortgage before and are into their second or third renewal — they might be more willing to try variable having watched the market and seen where they could save money.”

Okun estimates that a third of her clients go for variable, which mirrors the results from the 2018 Annual State of the Residential Mortgage Market in Canada study by Mortgage Professionals Canada where 30 percent of mortgages purchased in 2018 had a variable rate.

We’ve been in an environment of rising interest rates since the summer of 2017. Between then and October of last year, the Bank of Canada hiked the overnight rate five times, in response to the weakened energy sector. “When we were seeing prime go up, that was stressful for people who had variable rates,” says Okun. “That said, it really depends on the discount you’re getting with your variable rate. Now, I’m seeing rates that are prime minus 1.05.”

Sometimes banks will promote very attractive fixed rates for short terms (one- to two-year). You might find lower interest rates than a five-year variable mortgage, but Okun advises to steer clear. “It’s most profitable to banks to have you roll over into a new product more often. Sometimes people think they’re getting some kind of security on that two-year fixed rate, similar to the discount that they would get on a variable rate. But if you are looking to save money, you are, generally speaking, better off on a five-year variable product than you are with a two-year fixed.”

Photo: James Bombales

How do you decide?

To help her clients decide, Okun sets up a scenario where she compares the monthly payments of a fixed-rate mortgage against hypothetical increases on a variable mortgage.

Okun begins by mapping out your monthly payments each month for the next five years with a fixed mortgage. This part is pretty simple, since it’s the same every month. If you go with variable, she will outline your payment for the first six months based on the prime rate and your discount, then increase prime by five basis points every six months until the end of your term, demonstrating what you’d pay each month.

Let’s say at the outset, you have a variable mortgage and are saving $600 a month. Then prime goes up and you’re saving $400 a month. “Usually two and a half years in, you get to the break even point,” says Okun.

But keep in mind, in the first two years, your first mortgage payments will be interest-heavy. As your loan’s principal goes down over the years with more payments, so too does the interest you’ll pay on it. “For the last two and a half years of your term, you might lose money with variable. But it’s on a declining balance, so you’re losing less than you would have at the outset. At the end of five years, maybe you’ll still come out $1,000 ahead.”

If you have a large discount on prime, this is a no brainer. “But if your discount on prime is only 35 basis points, the savings are going to be so minimal, it probably won’t be worth it,” says Okun.

Photo: James Bombales 

Consider the fine print of breaking your mortgage.

It’s always challenging to know where your life is going to take you but going with a variable mortgage can make it easier to plan for the what-ifs. If you need to break a fixed-rate mortgage before the end of the term, the penalty is aggressively large. Even if you’re risk averse, it’s much easier to break a variable rate mortgage, where the penalty is three months interest. With a fixed rate, the penalty is three months interest or the interest rate differential, whichever is greater. “The interest rate differential is the difference between the rate that you have and the rate of the day, and the banks do a calculation based on that. Whatever is more profitable to the bank will be the penalty applied to you,” says Okun.

It’s a dangerous game to simply focus on the interest rate, without reading the fine print of your mortgage product. In some cases, even if you were willing to eat the penalty to break a fixed-rate mortgage, you wouldn’t be allowed to. “People need to be aware of ‘no frills products.’ The rate may be very good but they make it very difficult to leave,” says Okun. “There are some products where the penalty to leave is three percent of the balance. You would never break that mortgage. I have seen mortgages that have sale-only clauses — you cannot break that mortgage unless you sell your property.”

Photo: James Bombales 

Love your mortgage

Going with a variable-rate mortgage is a gamble. In an era of rising interest rates, there can be instances where homeowners with fixed-rate mortgages will come out ahead. If you already have a variable mortgage, should you jump ship?

“Rates are changing all the time. They may fluctuate weekly,” says Okun. “You get the mortgage that you get at the time that you buy it. I think you have to love your mortgage and love your decision. You got a house, you can afford the monthly payment.”

If you’re always keeping your eye on rates, you can drive yourself crazy. “Once you get your mortgage, just stop looking. Because there’s always a different interest rate, there’s always a new promotion on,” says Okun.

Okun has had clients get in touch to see if they can jump from variable to fixed, or take advantage of a promotion.

“I’ll do the math on it and say, ‘Well, with the penalty, you’re coming out $30 a month. Do you want me to do this for you?’ Sometimes, there is a good reason to break your mortgage — if there’s a huge difference between the rate you have and what’s being offered right now. Sometimes it is worth it to absorb that penalty based on the savings and interest that you’re going to have in your product. But it would have to be at least four or five basis points, otherwise, I wouldn’t bother.”

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