Variable and Fixed, Open and Closed Mortgages

I must confess, I didn’t know very much (well, still don’t really! There’s still much to learn) about fixed and variable mortgages, and what prime was etc. because I hadn’t ever encountered buying a place.  I got really confused with open versus closed and thought open meant variable.

Now that I’ve been looking to get a pre-approved mortgage before the April 19 mortgage rules changes and have amassed somewhat of a downpayment, I’ve been asking around and meeting different mortgage brokers, spoke to mortgage specialists at banks, and sponged up all the information they could give me.

They all probably think I’m really annoying because I met with them, they spent their time with me, and then I didn’t follow through right away, but I wanted to make sure I am making the best decision I am able to make (hey, it’s the biggest financial decision of our LIVES, I think it’s okay to be indecisive and noncommittal, right?).

I wanted to share some of what I learned with you all, so that you can sound like you’ve been doing some research when you meet your mortgage broker or bank mortgage specialist.  So here are some basics between variable and fixed and open and closed mortgages… that was a mouthful!

What is a variable or floating mortgage?

A variable rate mortgage (VRM), sometimes called a floating rate mortgage, is a mortgage where the interest rate fluctuates during your term.  The variable rate is related to the Bank of Canada prime interest rate (which is 2.25% right now).  That means, that if the Bank of Canada increases the Prime Interest rate, then your interest rate on your mortgage will go up too.  The banks and mortgage lenders give a slightly better rate than the prime interest rate.

For example, you may see “Prime minus 0.15%” discount to price their variable rate mortgages and compete with different banks and mortgage lenders.

The Bank of Canada uses the prime rate to adjust for inflation. When there isn’t very much inflation, the prime rate will remain low.  When inflation skyrockets, the prime rate will increase because the Bank of Canada needs to adjust for this.

Historically, choosing a variable rate mortgage saves you more money than choosing a fixed rate mortgage.

What is a Fixed Rate Mortgage?

A fixed rate mortgage, contrary to popular belief (including me!), is NOT linked to Bank of Canada’s prime interest rate.  The fixed rate mortgages are set by the chartered banks in relation to the yield in the bond market. The bond market is highly unpredictable and is related to the political and economic conditions present.  No one can predict what fixed rates will do, even in the short term, because of this volatility.  That’s why they change all the time.

The rates change, but once you lock them in for that term, that’s the interest rate that you will get.  Some people like fixed rates because they are guaranteed to be paying X amount over the term.  Even though the payments are fixed, most lenders will allow you to pay a little extra more to chip away at your principle amount.

What is a Closed Mortgage?

A closed mortgage means that you are agreeing to a term.  Terms can range from 6 months to 10 years.  If you back out of the mortgage before the term is up, you will have to pay a penalty.  Ellen Roseman, a columnist for the Toronto Star, reminds us that this penalty can be a shocker.  The penalty is usually three months of interest, or the Interest Rate Differencial (IRD) depending on which one is HIGHER (but variable rate mortgages don’t have the IRD). Canadian Mortgage News has a great calculator you can use to see how much your lender can gauge charge you.  It can be about $46,000 on a mortgage balance of 500,000 with 30 months remaining in the term and initial fixed interest rate of 5.70% vying for the current variable interest rates of 1.95%.  Poof.

So if you are getting a 10 year mortgage with someone that you’re not sure is “the one” (which you shouldn’t do, anyways, but I suppose no one goes into these things thinking about break ups!), then just be extra cautious because not only will your heart break, your bank will break too.

Related: How To Port A Mortgage

Also, let’s say you won the lottery (a cool million, let’s day dream) and your house is worth a million.  You can’t just pay off the loan just because you have the cash.  You will have to pay a penalty to do this.

To refinance you will also have to pay a penalty.  For example, if you were in a fixed mortgage rate and saw that the variable rate is so low and so you wanted to get in on some action.  You could, but it will cost you!

So with all this downside to having a closed mortgage, you might think what’s the point, why not get a mortgage that doesn’t have any rules, circa 1969 man.

Well, because open mortgages charge you more in interest.  There had to be a catch somewhere, right?

What are Open Mortgages?

An open mortgage, as mentioned above, is a mortgage with no rules.  You can pay back the money you borrowed any time.

You could buy a house in January and sell it in March if you wanted, and not have to pay a penalty for breaking the term.

For variable open mortgages, for example, instead Prime MINUS 0.X%, it’s Prime PLUS 0.X%.  The bank puts in all this effort in lending you money, so they need to try and make some money off you, because you could leave anytime you want.

Hope that little summary gives you a bit more grounding on making the BIGGEST FINANCIAL DECISION OF YOUR LIFE!  In my books, knowledge is power =)  Out of curiosity, to all you homeowner readers out there, did you pick open or closed and fixed or variable?

About

Young is a writer and former owner of Young and Thrifty and the main "twitter' behind Young and Thrifty's twitter account. She lives in Vancouver, BC and enjoys long walks on the beach, spending time with her anxious dog, and finding good deals. If you like what you read, consider signing up for email updates.

16 Responses to Variable and Fixed, Open and Closed Mortgages

  1. @Young & Thrifty – We picked a closed mortgage (unfortunately) a few years back. We did so because my wife wanted the security against rising interest rates, although I was more than willing to watch the rates… Oh well. “They” (the experts (economists)) said interest rates were going to rise. That was in 2007. Here we are, spring 2010, just on the cusp of that reality. We’ve paid more than we should have in mortgage interest, but we’ve been able to actively budget around that fixed payment as well, making lump-sum mortgage payments on top of our regular payment, so all is not lost :) Nice post!
    .-= Financial Cents´s last blog ..Personal finance and golf parallels, and blogs to read this weekend… =-.

    • @Financial Cents- That’s good that you’ve been able to make lump sum mortgage payments- it helps chop away at that beast. Thanks for sharing your mortgage choice! =)

  2. Good stuff for all the young and thrifty out there.

    When I bought my place I was one of those sub-prime mortgage people! 5% down, Interest only mortgage 10yr-ARM (YIKES!)…. I learned my lesson and was lucky enough to refinance and get a fixed-rate 30 year at a touch over 5%. There is something very nice about knowing what my payment will be each month for as long as I own the house. I make additional payments to payoff the principle but am thrilled to be out of the Variable Rate Business.

    • @Investing Newbie Great! I have a post scheduled for Wednesday that talks about Variable vs Fixed =) The Open Fixed Rate doesn’t have that long of a term (usually 6 months to 1 year) and the interest is MUCH higher than a closed fixed rate. For example, at CIBC (a bank from Canada) the open fixed rate is currently 6.45-6.70%. With a 5 year fixed rate, you could get something as low as 3.80%. I guess it’s okay if you plan to flip the house and you think that the real estate market is going to pop within short term. =) (pop as in go higher, not housing bubble burst!)

      @Larimerboy Wow, how did you sleep at night? =) It’s kind of funny (or rather, scary) how people can just approve you just *like that* (I was snapping my fingers) without really checking if you can truly afford something- it’s like you almost need to tell yourself what you feel comfortable with, otherwise, the bank will just max you out. Glad that you’re feeling more comfortable now- it’s nice to know what you have to pay each payment. =)

  3. This is a great post. I want to get into Real Estate but I don’t know a lot of the vocab and I’m not 100% that I should buy property. I’m looking forward to more posts on this. Sounds like the best mortgage is an Open Fixed Rate, though.

  4. Thanks to the advice of a wise friend who also happens to be a mortgage broker, I lucked in to an open variable mortgage at Prime -0.7% in the summer of 2008. Immediately after which the prime rate started plummeting, yay for me! I’m sticking with the variable rate and paying more than if I had a fixed 5 year rate, plus throwing the odd lump sum at it. I’ve already reduce the amortization from 20 to 8 years and figure I’ll get it close to paid off before the rates ever get close to what they were as fixed rates when I signed.

  5. Hey,
    I haven’t been in on the variable vs Fixed debate in a while. We’ve been focusing on helping our clients and readers with tips on budgeting to reduce costs. I guess saving on mortgages does tie in a fair bit.

    Just wondering if you heard that the Royal Bank raised it’s rates today. Don’t you think the others will follow suit and that this is one of many rate increases?

    Oh, and have you heard of the DoFollow plugin for WP?
    .-= Guy G.´s last blog ..Grocery Saving Tips – Tips on Budgeting =-.

    • @Guy G. Yup! Heard that RBC raised their rates. Yup, I think that others will probably follow suit… I hear that at the credit unions, you can still get some good rates, like 3.69% for a 5 year fixed. I guess it’d be helpful to a) negotiate like mad or b) try and find a mortgage broker…

      @chantl01 PRIME -0.7% that’s awesome!! Wow you were probably paying like.. 1.5% interest- crazy! That’s the strategy that I plan to use. That’s amazing that you reduced the amortization from 20 to 8!! You’ll be debt free in 8 years! Congrats!

  6. I really don’t find fixed interest rates to be a rip off. Regardless of what interest rates do in Canada or elsewhere, I see interest as a way for banks to not lose money through inflation when they lend to you–inflation in my opinion is bound to beat interest rates in the next 10 years. The housing market can’t crash that much more. . .can it?

    I would want to have a fix interest rate on any mortgage I took out because I would want to be absolutely sure how much I was going to pay–and that I can afford it. But . . .I really don’t like risk. It’s not always my investing strong point–however, in the past couple of years, that has served me well.
    .-= Simple in France´s last blog ..How do you chose a ‘new’ car? =-.

    • Thanks for visiting, simple life. Yeah part of me isn’t good with risk either and part of me wanted to go fixed.. I think if it were my own mortgage instead of one with my boyfirend I might go fixed :)

  7. I think it is useful to hear about fixed and variable rate mortgages from yourself as you explain things in simple terms, without all of the unnecessary marketing garb that so many companies use. I really like the fixed rate nature of most investments, be it mortgages or bonds as i can easily budget then but what is actually best in the long term i believe is impossible to be sure.

  8. Thanks for explaining what all the different types of loans are as I recently talked with a lender and was totally lost. I am leaning towards getting a fixed rate mortgage right now but I just don’t know if I will qualify and still get a decent rate.

    Pam

  9. With a fixed rate mortgage, the mortgage rate and payment you make each month will stay constant for the term of your mortgage. With a variable rate mortgage, however, the mortgage rate will change with the prime lending rate as set by your lender.
    Fixed mortgage rates eases budgeting anxiety and offers stability. But then if the difference between the variable and fixed rate is significant, it may not be worth paying a premium for the stability protection of a fixed rate. On the other hand variable rates have proven to be less expensive over time.
    Open mortgages allow you to prepay any amount of your mortgage at any time without a compensation charge. You can also make additional payments without penalties. Open Mortgage terms range from 6 months to 5 years and can have variable or fixed interest rates. Closed mortgages have a prepayment limit, which means you are only permitted to pay 15% of the original principal balance of the mortgage per calendar year. If you elect to pay more than 15% within a single calendar year, compensation charges will apply. To reduce the penalties you can discuss with your mortgage brokers. This type of mortgage is more stable due to its restrictive nature, which is why interest rates are lower than they are for open mortgages.

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