5 key points to consider.
Once you have decided that you would like to buy a house, the first thing you need to figure out is how to finance the purchase. This means deciding how much of your savings you are going to be used as a down payment and how much money you’d want to borrow (the mortgage) as the right type of mortgage. While there are several types of mortgages on the market, the two main types of loans are fixed-rate and variable-rate mortgages.
Fixed rate mortgage
A fixed rate mortgage is one where your mortgage payments are fixed and remain the same throughout your mortgage term. For example, if you have selected a 5-year fixed rate mortgage and your monthly mortgage payments are $3,000. This means that you will be paying $3,000 every month for the whole term. Changes in interest rates or prime lending rates will not impact your monthly payments.
Variable rate mortgage
Variable mortgage fluctuates during the mortgage term depending on or changes to the prime lending rate set by your lender. Basically, when interest rates fluctuate, your payments fluctuate as well. This could mean that your overall payment amount changes, or it may stay the same and the change will be reflected in the proportion of your payment that goes towards paying down your loan’s principal vs. interest.
For example, when the banks’ prime rate goes up, your variable mortgage rate increases. Depending on how your mortgage is set up, this can result in an increase of your monthly mortgage payment, or more commonly, your payment will stay the same, but a greater proportion of it will go towards paying off interest.
Your income, lifestyle and risk tolerance will weigh heavily on your decision and will inevitably determine which mortgage product suits your circumstances. And the type of interest rate you choose could impact the amount of money you save over the home loan term, so it’s worth considering the following factors before you seal the deal:
Reliability and peace of mind
There is a good reason why most people choose fixed rate mortgages. New homeowners often want the peace of mind that comes with knowing exactly what they are on the hook for, each month, to cover their mortgage obligations. They don’t want any surprises and are willing to pay slightly more for the assurance that there will be no increases in their payment amount for the term of the mortgage.
Even though a variable rate mortgage will be cheaper at the time of closing, and may even fall further over time, the issue here is risk of the unknown. And as rational beings, the majority of people are risk-averse.
If you are putting down a hefty down payment, or are renewing a mortgage and have a low mortgage balance, the risk you face from sudden spikes in interest rates is much lower. In this case, a competitive variable mortgage rate can be very attractive and would also be easier to qualify for.
Depending on your financial situation, how much you are putting down as down payment, and if you are a low or high-ratio borrower, it may be easier for you to get approval for a fixed rate mortgage, than a variable one. Depending on your loan-to-value ratio, the variable rate you are offered may differ. So, if your income means you will find it difficult to absorb a rate hike that significantly increases your payments, a fixed rate mortgage may be preferable.
PENALTIES WHEN YOU MOVE OR SELL
The penalties incurred when you break a fixed rate mortgage is usually much higher than for a variable rate mortgage. If you know that you may need to move or sell your home before the end of the common 5-year fixed mortgage term, you should consider a shorter fixed rate term or go with variable. In addition, you can choose a mortgage that has favorable portability options. Breaking or renegotiating a variable mortgage will cost you about 3 months in interest payments. Whereas, for a fixed mortgage, you can expect to pay the greater of 3 months’ interest or the interest rate differential – this is often costlier.
BEFORE YOU DECIDE, ALWAYS COMPARE
Taking out a mortgage can be a quite overwhelming. Choosing a fixed rate or a variable rate is one of a number key decisions you’ll make when buying a home and it’s important to have all of the information available before committing.
Whatever way you look at it, choosing what rate to go with is going to be a gamble. Property prices and global interest rate trends are notoriously difficult to predict, but by knowing the value you place on certainty and peace of mind, you will be in a good position to decide whether you should fix or vary your repayment rate.