Together, with friends atThe Loop by Sympatico.ca, we decided that the most commonly misunderstood part of buying a home is the calculations that go along with it. As a result, Mortgage Math was planned and produced for homebuyers at any stage in the buying process.
Once you’ve figured out how much you can afford to borrow, found your dream home and pre-qualified for a mortgage, it’s time to make some decisions about your mortgage. One of the biggest decisions you’ll have to make is whether you want a fixed rate or a variable rate mortgage. While there are advantages to both, you’ll want carefully consider which option is best for your budget and your lifestyle.
In our fourth Mortgage Math video, Mortgage Broker Ian Mackay from Redpath Financial walks you through the differences between fixed rates and variable rates, and shows you how your monthly mortgage payments may vary depending on which option you choose.
When you’re ready for a mortgage, you’ll have to decide whether to go variable or fixed. With a fixed rate mortgage, your interest rate and monthly payment will stay the same across your term. With a variable rate, on the other hand, your interest rate and monthly payments are likely to fluctuate over the course of your term. We’ve brought in mortgage broker Ian MacKay to walk you through both types of rates and show you the differences in more detail.
As Alyssa mentioned, your variable rate mortgage will start with a lender’s prime rate. The lender will either offer you a premium or a discount to their prime rate.
In this illustration, your lender has offered you a variable rate mortgage at a discount of Prime minus 0.45 per cent. With the current prime rate of 3 per cent, your effective interest rate for your variable rate mortgage is 2.55 per cent. If the prime rate were to increase to 4 per cent, your effective interest rate would be 3.55 per cent. And if prime rate increased to 5 per cent, your effective interest rate would be 4.55 per cent.
Important points to consider are that your relationship with Prime never changes throughout the term, and that Prime can change based upon the bank’s overnight lending rate.
Let’s say you just purchased a home for $300,000, and have a 5 per cent down payment. In this example, with a 5-year fixed interest rate of 2.9 per cent, you would have a monthly mortgage payment of $1,375. With a variable rate mortgage, with an effective interest rate of 2.55 per cent, you would have a monthly mortgage payment of $1,319. In this example, the variable rate mortgage payment is less; however, you must consider that your payment can fluctuate throughout the length of the term.
Two years into your term, Prime has increased to 4 per cent. What that means is the effective interest rate of your variable rate mortgage has increased to 3.55 per cent. That also means that your effective monthly mortgage payment has increased to $1,470.
Now, let’s look at how much these interest rates would cost you over a 5-year term. Since fixed interest rates remain the same over five years, we simply multiply the payment over sixty months. That would give you an effective mortgage payment over five years of $82,500.
For the variable rate, we must take the payments for the first two years when the rate was 2.55 per cent and then calculate the payments for the last three years when the rate was 3.55 per cent. The payment for the first two years is $31,656, and the payment for the last three years was $52,920, for a total of $84,576.
In this example, payments for the 5-year fixed are lower than the 5-year variable rate. However, that is not always the case. For the 60 per cent of Canadians that prefer the stability of a fixed interest rate, variable rate interest rates have been lower over the past 10 years.
A fixed rate provides stability and eases budgeting anxiety because it is constant over the creation of the term. However, when the fixed rate is significantly higher, the stability is often not worth the premium.