With interest rates dropping quickly in September 2024, it might be tough to decide between a fixed or variable mortgage rate. Both have their perks and pitfalls, so let’s break down what you need to know to make the best choice for your situation.
Fixed Rate Mortgages
Why Fixed Rates Might Work for You
Fixed-rate mortgages offer the advantage of predictable payments, making it easier to budget and plan your finances. You know exactly what you’ll pay each month regardless of market fluctuations. Currently, fixed rates are over 1% lower than variable rates, which provides a significant cost advantage if you value stability and want to avoid the uncertainty of future rate changes.
Fixed rates also shield you from economic volatility. For example, in 2022, the prime rate surged by more than 2%, causing variable rates to climb quickly. If you had a fixed-rate mortgage at that time, you wouldn’t have been affected by these sudden increases, providing financial predictability during turbulent times.
The Downside of Fixed Rates
Fixed-rate mortgages might come at a higher long term cost compared to their variable counterparts. If variable rates decrease significantly—say, by 2% by the end of 2025—you might miss out on potential savings. Variable rate holders will have the option to switch to the lower fixed rates available with minimal to no penalties, where as fixed rate holders will not. Breaking a fixed-rate mortgage early can be costly due to prepayment penalties, which can be a significant consideration if you plan to sell your home or refinance before the term ends.
Variable Rate Mortgages
The Upside of Variable Rates
Variable-rate mortgages can be financially advantageous if interest rates drop. For instance, if you lock in a variable rate at 5.55% and rates fall to around 3.55% by 2025 with potential to reduce even further, you could save a substantial amount over the life of your loan.
One of the primary benefits of variable rates is their flexibility. You can often convert your mortgage to a fixed rate without incurring extra fees or having to requalify, which can be a strategic move if rates become more favorable. This can be done by just calling up your existing lender and asking them to convert you into a fixed rate.
Additionally, variable rates typically have lower penalties for early repayment compared to fixed rates. This flexibility can be beneficial if you’re planning to sell your home, refinance, or switch lenders in the future.
The Risks of Variable Rates
Despite their potential savings, variable rates come with risks. They can increase if the economy worsens, leading to higher monthly payments and more interest paid over the life of your mortgage term. Currently, variable rates start over 1% higher than fixed rates, which means you might pay more initially. Some lenders may not adjust your monthly payment in response to rate changes, instead altering the portion of your payment that goes towards principal versus interest.
Long-Term vs. Short-Term Strategies
When choosing between fixed and variable rates, consider your long-term financial goals and housing plans. Fixed-rate mortgages are ideal if you plan to stay in your home for many years and prefer the certainty of fixed payments. On the other hand, if you anticipate a move or refinancing in the near future, a variable-rate mortgage or a shorter-term fixed rate could be more cost-effective. For those who prefer a middle ground, short-term fixed-rate mortgages, such as a 3-year term, can offer competitive rates while allowing for future flexibility.
The Role of Inflation and Central Bank Policies
Inflation and central bank policies are key factors influencing interest rates. Central banks, like the Bank of Canada, adjust their overnight rates based on inflation and economic growth. When inflation is high, central banks may increase rates to cool down the economy, leading to higher borrowing costs. In a low-inflation environment, central banks might lower rates to encourage spending and investment. Keeping an eye on these macroeconomic indicators can provide insights into potential future rate movements.
Calculating the Break-Even Point
Another thing to add, it’s helpful to calculate the break-even point between fixed and variable rates. This involves comparing the total cost of each option over the expected life of the mortgage. For instance, if you’re considering a fixed-rate mortgage with a higher interest rate versus a variable-rate mortgage with the potential for lower rates, calculating how long it would take for the savings from the variable rate to offset the initial higher cost can help you decide. Consulting with a mortgage professional will help you determine this.
My Personal Choice – Variable
Ultimately, choosing between a fixed and variable mortgage rate is a personal decision that should be based on your financial situation, risk tolerance, and long-term goals. If I had to look into my crystal ball and take a guess at what would outperform in interest savings between a 3 year fixed and variable rate, I would hedge my bets towards the variable. With the option to convert it into a fixed at anytime at no fees, and the potential to break it at low penalties too, makes it an option I would personally consider. The expectation of further rate cuts for the variable and lower fixed rates in the future makes it even more attractive. Remember, this does not mean that this option is right for everybody.
Conclusion
Choosing between a fixed and variable rate mortgage involves weighing stability against potential savings. Fixed rates provide predictability and protection from rate hikes, while variable rates offer flexibility and the chance to benefit from lower rates in the future. By understanding the benefits and risks of each option and consulting with a mortgage professional, you can make a decision that aligns with your personal financial goals and personal circumstances.
