Having bought three properties in ten years, I’m here to give a crash course on open vs. closed mortgages and fixed vs. variable rates. These are two important concepts to understand before signing on the dotted line of your mortgage agreement, as whatever you choose has a big impact on what you’ll pay over the long-term.
One of the most important things you’ll have to decide is whether to go with a fixed vs. variable rate mortgage. Let’s look at the differences.
What is a Fixed Rate Mortgage?
A fixed rate mortgage is pretty straightforward. Here’s how it works: your lender offers an annual percentage rate and term, such as 2.80% for five years on a $500,000 loan, which will be paid back over 25 years. Since it’s a fixed rate mortgage, the interest rate will stay at 2.80% for the full five-years, even if the prime rate fluctuates during that time period (more on that later). With a fixed rate, you make the same monthly, bi-weekly, or weekly installments, which goes towards paying down both the interest and the principal (the amount you borrowed).
A fixed rate mortgage tends to be a favourite among Canadians because it offers peace of mind. According to the Mortgage Professionals Canada (MPC), 68% of borrowers who purchased a home in 2018 chose a fixed rate mortgage. It’s easy to see why: you know exactly what your mortgage payment will be every month and it never changes (at least, until the term is up). That way, you can make a budget that will help you live within your means.
The cons are that this security blanket comes at a cost. Fixed rate mortgages are usually higher than variable rate mortgages. Also, if variable interest rates plummet, you’ll be stuck paying a higher interest rate.
What is a Variable Rate Mortgage?
Like fixed rate mortgages, variable rate mortgages (VRMs) also have a set term (e.g. 5 years), but they have one big difference: the interest rate can go up and down during your mortgage term. This can happen as often as every month, as it’s tied to whatever is happening with the rate set by the Bank of Canada.
How does it work? The variable rate is related to the prime interest rate, which refers to the interest rate that a bank offers to their most trusted customers. This preferential rate is based on the Bank of Canada’s overnight rate or key interest rate – which is the interest rate at which banks get money from the Bank of Canada.
The bottom line: if you choose a VRM, your payment will go up or down depending on what the Bank of Canada does and how your lender reacts with their prime interest rate. While some people think can predict what the Bank of Canada is going to do, the truth is that no one has a crystal ball and can see what interest rates will do over the long term.
You may see banks advertise their variable interest rates as “prime minus 0.2%” or something similar. This means that you will get 0.2% off of the floating prime interest rate – which could go up or down (or stay the same) throughout your mortgage term.
Another consideration for VRMs: set vs. fluctuating payments. You have a choice with VRMs: make set payments (the same amount for every payment) or payments that fluctuate. If you choose a VRM with a fluctuating payment, your mortgage payment can change at any given time. In contrast, for VRMs with set payments, you’ll pay the same amount every time. For instance, if you’ve agreed to pay $1000 bi-weekly, it will stay $1000 – no matter what happens. But if the rate drops, more of that $1000 will go towards paying down the principal balance. If the prime interest rate increases, more of the payment will go towards paying off interest. Ultimately, this impacts your amortization schedule – meaning the time it will take to repay your mortgage in full.
A big pro is that VRMs tend to be a lower interest rate than a fixed rate mortgage. According to the Mortgage Professionals Canada (MPC), the average difference between a fixed and variable mortgage rate in 2018 was 0.55%, which works out to about $85 per month difference in payments. Historically, VRMs cost less in interest over the mortgage amortization, and you can save a bundle if you go with a VRM.
The cons? Your interest rate could go up suddenly, so make sure you can afford your property if this happens. For instance, if you buy a property at the very top of your budget, a hike in the interest rates could jeopardize your ability to make payments on your home. Just do the math before committing to a VRM.
Variable vs. Fixed Rate Mortgage: How to Choose
Choosing between a variable vs. fixed mortgage really comes down to your financial circumstances. Are you comfortable with fluctuation payments? Do you have debts or big-ticket expenses to tackle in the near future? Is your employment precarious or do you have a steady paycheque coming in every month? Is your priority to pay off your mortgage early or invest the extra cash? It’s really a personal choice and you’ll need to crunch the numbers to figure out which one is right for you.
There is a third option when it comes to mortgage interest rates called a hybrid mortgage. This is essentially when a mortgage agreement has a certain portion of the amount borrowed as a fixed rate, and the rest as a variable rate. This option is rarely chosen by Canadians but can offer an interesting middle-ground when it comes to risk and reward.
If you’re stressed about the mortgage stress test, consider a credit union like Meridian. As a provincially regulated financial institution, Meridian has more flexibility than traditional banks when it comes to the mortgages they offer and approve. The stress test can help evaluate whether a mortgage is a good fit for a borrower, but at Meridian, you’re not automatically disqualified if you don’t pass it. This is because they consider other factors, like income appreciation, accelerated payment options, and overall principal reduction. The bottom line: if you don’t pass the stress test, a credit union like Meridian will work with you to find flexible solutions — making it easier to afford your dream home. Plus, Meridian has some fantastic fixed and variable rate mortgages (some of which are even lower than the big banks!), as well as plenty of mortgage options to suit your circumstances.
What is an Open Mortgage?
With an open mortgage, you can pay off your mortgage at any time without a penalty. However, the interest rates for an open mortgage tend to be variable and much higher.
What is a Closed Mortgage?
In contrast, a closed mortgage has rules about how much you can pay down on your mortgage. If you pay down your mortgage before the term ends, your lender will charge you a hefty penalty.
It may feel like you’re locked in with a closed mortgage but remember that most lenders allow you to make “pre-payments” (extra payments over and above your normal mortgage payment) up to a certain amount annually. This allows you to pay a certain percentage of the original mortgage amount without penalty. Meanwhile, full payoff requires that you pay a penalty – unless you wait for your maturity date. So, if you suddenly find yourself swimming in cash, a pre-payment on a closed mortgage can still be a good option.
Open vs. Closed Mortgage: How to Choose
Again, there’s no “right” choice here: it really depends on your financial situation and personal preferences. Generally, most Canadians prefer the simplicity of a basic closed mortgage with fixed interest payments. It’s easy to understand and there are no surprises. But if there’s a chance that you may inherit a wack of cash in the near future, you may want to opt for an open mortgage so you pay it off faster and incur less interest. It’s totally up to you.
Last Word: How to Find the Best Mortgage?
The most important take away is that you really need to do your research to find the best mortgage. The options are endless and it’s like buying an expensive suit: it needs to be tailored to fit you.
The moral of the story? Stay calm and carry on. Buying a house marks an exciting chapter in your life and try not to get too bogged down in the paperwork. Do your research, ask questions, and make an informed choice. Plus, remember that your term expires at some point, and you can make changes when that time comes.