When acquiring a property, the new owners must opt for one of two types of interest rates for their mortgage loan: a fixed interest rate or a variable interest rate.
Understanding the difference between these two options—and there are advantages and disadvantages to each—will help you make an informed decision that corresponds to your financial situation.
What Is a Fixed Rate Mortgage?
A fixed interest rate mortgage is a loan for which the interest rate remains constant throughout the entire term. This means that your monthly payments will stay the same, regardless of prime interest rate fluctuations, that is to say the minimum interest rate financial institutions use to determine the interest rates they charge on their loans. It should be noted that the prime rate primarily varies in relation to the key interest rate set by the Bank of Canada.
The Advantages of a Fixed Rate
- Financial Predictability
You will know exactly how much you will pay month to month, simplifying long-term budget planning. It will thus be easier to plan projects, like a trip, or larger occasional purchases, for example.
- Protection Against Prime Rate Fluctuations
A fixed rate provides protection against unexpected prime rate hikes. As we’ve seen in recent years, many homeowners who had opted for a variable rate found themselves facing payment difficulties due to the rising prime rate. In fact, the larger the mortgage, the greater the impact of rate increases.
- Ideal for Cautious Buyers
Do you have a low risk tolerance and prefer stability? Then a fixed rate is probably the best choice as it offers guaranteed peace of mind!
The Disadvantages of a Fixed Rate
- A Higher Cost for Stability
Over the long term, a fixed-rate loan is more expensive because, as a general rule, fixed rates are higher than variable rates. Stability has a price!
- Less Flexibility
If the prime rate comes down, you won’t benefit, losing out compared to the people who had chosen the variable rate.
What Is a Variable Rate Mortgage?
Conversely, a variable rate is an interest rate that may fluctuate based on the prime rate.
The Advantages of a Variable Rate
- A Lower Rate
Variable interest rate loans allow you to take advantage of a lower rate, possibly saving you a lot of money in the long run.
- Greater Flexibility
If the prime rate drops, so may your interest rate, once again, helping you save.
The Disadvantages of a Variable Rate
- Financial Uncertainty
Your monthly payments may go up along with the prime rate, potentially making budget planning harder.
- Rates May Go Up
You may end up paying significantly more than you initially planned during periods of climbing interest rates. This has gotten some households in hot water in the past.
- Requires More Management Skills
It can be complicated and time consuming to keep track of interest rate fluctuations and how these may impact your payments.
Scenario 1: A Fixed Rate
Gabriel and Simon, a couple with two children, have found their dream home and have decided on a fixed-rate mortgage. As professionals with stable jobs, they value security and predictability. Their fixed rate loan guarantees stable monthly payments, facilitating financial planning. While they understand that fixed rates are slightly higher, the peace of mind this provides is worth the extra investment.
Scenario 2: A Variable Rate
Anna, an ambitious young professional, has decided to invest in her first condominium. She opts for a variable rate mortgage, lower than a fixed rate, with the hope that rates may come down in future. She knows that she has the financial means to absorb rate fluctuations and she’s willing to risk possible interest rate increases. Her goal is to use potential short-term savings to invest in other real estate projects.
As you can see, there is no single right answer to the question of which rate you should choose! What’s right for one person may not be appropriate for another. A financial advisor or a mortgage broker can help you fully understand what each option entails.