Buying a house and getting a mortgage can be a stressful experience – especially if you’re going through it for the first time. Whether you’re going through a traditional bank or a mortgage broker, with terms such as variable, fixed, closed, open, prime interest rates and many more, it can be easy to get intimidated. Because of all this new information zipping past you it’s unfortunately very common to misunderstand important details when it comes to what is often the most important purchase of our lives.
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Since I’ve been looking to get a pre-approved mortgage for a while now after amassing a down payment (check out the free ebook if you want to know more about how I saved for a down payment) I’ve been researching and meeting with a variety of mortgage brokers and bank specialists. 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 with your mortgage people. Here are some basics when it comes to variable vs fixed and open vs closed mortgages.
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 that you are paying can go up or down during your mortgage term. The variable rate is related to the prime interest rate. The term “prime interest rate” refers to the interest rate that a bank extends 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 rate at which banks get money from the Bank of Canada. All of this means that if you choose a variable mortgage, your payment will go up or down depending on what the Bank of Canada does and how your bank (or other lender) reacts with their prime interest rate. While some people think they know what the BoC is going to do when it comes to interest rates, the truth is that no one knows what interest rates will do over the long term.
You will often see banks advertise their variable interest rates as “prime minus .2%” or something similar, which means that you will get .2% off of the floating prime interest rate – which could go up or down (or stay the same – the most common occurrence lately) throughout the length of your mortgage term.
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Historically, choosing a series of variable rate mortgage terms over the course of your overall mortgage will save you more money versus choosing fixed rate terms each time your mortgage comes up for renewal. Yet Canadians still tend to drift towards fixed interest rates because of the predictability and safety factors.
What is a Fixed Rate Mortgage?
Fixed rate mortgages are a little easier to understand and have remained a favourite amongst Canadians for years. The basic idea is that you sign on for your mortgage term of X years at a specific rate, and during that time the bank can’t change your interest rate regardless of what the Bank of Canada or the prime interest rate does.
In return for this simplicity and security, banks and other lenders will demand a premium. Consequently, expect to pay a little bit higher interest rate if you choose this option (banks have to protect themselves against possible interest rate rises after all). This is ultimately why sticking with a variable rate has proven to almost always be cheaper over the long term, even though they do entail some risk of rising interest rates in the short term.
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.
What is a Closed Mortgage?
When it comes to your mortgage, the terms closed vs mixed essentially refer to the ability to pay off all of the remaining money that you owe on a mortgage loan and be done with the loan instantly at any point in time. Most Canadians prefer the simplicity of a basic closed mortgage with fixed interest payments. They are easy to understand and there are no surprises; however, closed mortgages cannot be fully paid before the end of their term. Most lenders allow limited pre-payment privileges (i.e., extra payments over and above your normal mortgage payment). These privileges allow you to pay a certain percentage of the original mortgage amount with no penalty, but full payoff requires that you pay a penalty – unless you wait for your maturity date.
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The vast majority of Canadians don’t have the means to pay their mortgage off all at once or at an extremely accelerated rate; therefore, most aren’t worried about the fact that they are “locked in” for the length of their term. In exchange for sacrificing some flexibility with a closed mortgage, lenders will usually reward you with a significantly lower interest rate compared to an open mortgage. Typically, the majority of rates you see displayed on rate comparison sites or bank advertisements are for closed mortgages.
What are Open Mortgages?
An open mortgage is appropriate for people who want flexibility built into their mortgage. You can typically pay off an open mortgage at any time without penalty or convert it to a closed mortgage. Some people like this flexibility if they expect to sell their home relatively soon, or come into a large sum of money, which they can use to pay off their entire mortgage.
For more information on fixed vs variable rates, closed vs open rates, and other mortgage stuff like down payments, mortgage contract details, the Home Buyer’s Plan, and much more, download our FREE eBook: Getting Your Foot In The Door: The Ultimate Guide to Buying a Home in Canada.