This is the question that many find themselves asking. With what seemed to be an unrelenting rise in interest rates resulting in mortgage payments and other debt obligations no doubt becoming more difficult for an increasing number of individuals and families to meet, many wonder if now is the time to consider converting that variable rate mortgage to a mortgage with a fixed interest rate?
Understanding the difference between a fixed rate mortgage and a variable rate mortgage is key when making the decision that best meets your needs. Everyone’s situation is different, and this is not where a one size fits all approach is appropriate. Your circumstances and financial situation will play a large role in the decision you make.
What Is A Fixed Interest Rate?
A fixed interest rate is just that. The interest rate remains the same for a set length of time; typically, a 3-year term or 5-year term. With a fixed interest rate there is security in knowing what your payments will be and how much of that payment will go toward interest and how much toward principal. A potential downside is that with a drop in interest rates you will not be able to take advantage of the drop without incurring a penalty for breaking your existing term.
What Is A Variable Mortgage Rate?
A variable rate mortgage offers flexibility. Where there is a drop in interest rates, more of the payment is applied toward the principal, allowing you to potentially pay off your mortgage quicker. Conversely, with a rise in interest rates, more of your payment will go toward interest and less toward principal. Most variable rate mortgages provide for an option that allows you to convert to a fixed rate mortgage. So, while variable rate mortgages offer flexibility, they do not have the same budgetary security as a fixed rate mortgage.
How To Decide The Right Choice For You
Something to keep in mind when considering whether a fixed rate or variable rate mortgage is the right choice for you is the penalty your lender will charge if your mortgage is closed to early repayment, and you break your mortgage before the end of the term. With a fixed rate mortgage, your lender will charge a penalty of the higher of 3 months interest at the current interest rate on the remaining balance of your loan or the interest rate differential (IRD).
The IRD is determined by the calculations outlined in your mortgage documents. It can be significant, so it is important to understand that calculation prior to making any decisions or taking any actions to pay out your mortgage. With a variable rate mortgage, your lender will charge 3 months worth of interest on the remaining balance.
Consider Your Risk Tolerance
Currently, variable interest rates are higher than fixed interest rates which is a relatively rare occurrence and there are indications that interest rates will begin to drop throughout 2023 so whether you are looking to refinance, step into the real estate market as a first time home buyer or you are already in the market, when considering the type of mortgage that best meets your needs, you will want to know what your risk tolerance is as well as what your goals are. Consider whether it is budgetary security or flexibility that best helps you achieve those goals.
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