The Rate Debate
One of the first questions we hear from buyers is: “What will my interest rate be?”
It is easy to think that this is the most important question, but there is a lot more to your mortgage contract than just the rate. And so, the rate debate continues!
The rate debate is a hot topic in the mortgage world. Not just the numerical value of the rate itself, but the importance of the rate versus other factors in the mortgage, such as terms and penalties. As a borrower, it can be easy to get caught up in just the rate but ignoring other factors could cost you in the long run.
Before we get into these other factors, let’s talk rate. While not the only factor, it does continue to be an important decision criteria with any mortgage product. The interest rate is the percentage of interest you are paying on the principal loan; lower interest rates mean more money is paid towards the mortgage loan – and who doesn’t want that?
VARIABLE VS. FIXED
There are two types of mortgage rates: variable-rate and fixed-rate.
A fixed-rate is just that – a fixed amount of interest that you would pay for the term of the mortgage. A variable-rate, on the other hand, can fluctuate depending on the markets. A variable-rate is based on the current Prime Rate, which is based on the Bank of Canada’s overnight rate target.
Fixed rates are typically tied to the world economy whereas the variable rate is linked to the Canadian economy. When the economy is stable, variable rates will remain low to stimulate buying. When the economy is faced with inflation or other challenges, interest rate will rise to dampen market activity.
Fixed-Rate Mortgage: First-time homebuyers and experienced homebuyers typically love the stability of a fixed rate when just entering the mortgage space. The pros of this type of mortgage are that your payments don’t change throughout the life of the term. The downside is that should the Prime Rate drop, you won’t be able to take advantage of potential interest savings.
Variable-Rate Mortgage: As mentioned, variable-rate mortgages are based on the Prime Rate in Canada. This means that the amount of interest you pay on your mortgage could go up or down, depending on Prime. When considering a variable-rate mortgage, some individuals will set standard, sometimes called static, payments (based on the same mortgage at a fixed-rate). With this option, when Prime drops and interest rates lower, they are paying more to the principal as opposed to paying interest. If the rates go up, they simply pay more interest than to the principal loan. With this option, your payment amounts do not change. It is the ratio of how your payment is divided between interest and principal that will change. This is done automatically.
Other variable-rate mortgage holders will choose an adjustable variable rate mortgage. This simply allows their payments to drop with Prime Rate decreases, or increase should Prime go up. If considering this option, you will want to take a close look at your income, financial stability, and risk tolerance. Can you afford higher payments if Prime goes up?
BEYOND RATES
When considering your mortgage, other considerations such as penalties can be important factors for deciding on a mortgage product. If you have two competing products, say a 1.65% interest fixed-rate and a 1.95% interest variable-rate, it may seem like a pretty easy decision. But, what about the ability to make extra payments? What penalties could you be faced with?
Given that nearly 70% of fixed mortgages are broken before the term ends, penalties are an important variable. When looking at the fixed versus variable rate mortgage, penalties can be quite different. Where variable rates typically charge three-months interest, a fixed rate mortgage uses an Interest Rate Differential (IRD) calculation.
The aim of an IRD is to calculate the interest lost if your lender were to turn around and lend the funds at today's rates. Lenders use either their posted rate or the Canadian Bond Yield, which results in higher penalties.
Here’s how it works.
The IRD is calculated as the outstanding balance of your mortgage multiplied by the time remaining in your mortgage, multiplied by the difference between your mortgage interest rate and the current rate offered by your lender, including any available discounts, for the term closest to that which remains on your mortgage.
For example: you have a five-year term, and need to leave your mortgage early with three years (36 months) remaining.
IRD calculation
.06 (your interest rate) – .04 (current posted rate) = .02 (the difference between your existing interest rate and the bank’s current rate)
.02 x $300,000 (amount of mortgage remaining) = $6,000
$6,000 ÷ 12 (months) = $500 x 36 (number of months left on mortgage) = $18,000
Estimated IRD penalty payment: $18,000
Let’s compare that to a penalty that would equal three months of interest.
Three months of interest calculation
.06 (your interest rate) x $300,000 (amount left on mortgage) = $18,000
$18,000 ÷ 12 (months) = $1,500
$1,500 x 3 (months) = $4,500
Estimated variable-rate mortgage penalty payment: $4,500
In some cases, penalties for breaking a fixed mortgage can sometimes be two or three times higher than that of a variable-rate. While the interest rate may be lower with a fixed mortgage, the lower penalties associated with variable mortgages can be best if you anticipate breaking your term early for any reason.
CONVENTIONAL VS. HIGH-RATIO MORTGAGE
Another consideration beyond the interest rate is whether you will be obtaining a conventional or a high-ratio mortgage. Whenever possible, it is recommended to put 20 percent down payment on a new home. This results in a conventional mortgage. However, not everyone is able to do this! It is common for buyers to put less than 20% down and end up with a high-ratio mortgage product.
So, what does this mean?
High-ratio mortgages need to be insured by either Sagen, the Canada Mortgage and Housing Corporation (CMHC), or Canada Guaranty. This is due to the Bank Act, which only allow financial institutions to lend up to 80 percent of the purchase price WITHOUT mortgage default insurance. Insurance on the mortgage is important to protect the lender should you default on your payments.
The difference between conventional and high-ratio mortgages is that high-ratio mortgages require insurance, which results in an insurance premium. This is added to and paid along with the mortgage, so it is an important factor when considering your monthly payments. These premiums are based on the loan-to-value (LTV), which is how your loan amount compares to the value of your home.
All high-ratio mortgages are required to have mortgage insurance, but some homeowners with a conventional mortgage may choose to pay for mortgage insurance to get a better rate.
SMART QUESTIONS TO ASK
To ensure you understand your mortgage contract, and how it could affect you now and in the future, we have compiled a few smart questions to ask before you sign.
- What is my interest rate? Can I qualify for a better one?
- Do you recommend a fixed or variable-rate?
- What length of term should I consider?
- What are the penalties for breaking my mortgage?
- Can I make extra payments when I have money available?
- What options do I have if I want to pay my mortgage off early?
- Are there any pre-payment penalties?
- Will I require mortgage insurance? If so, what are the premiums?
- What will my monthly payment be?
- How much of an increase in my mortgage payments will I be able to afford if rates go up?
- If I sell my house before the scheduled maturity date, will I have to pay an extra charge?
- Is my mortgage portable?
These are just a few examples of good questions to ask. It is important to do your research and be diligent with any contract you are signing.
There is no single, magic mortgage option that works best for everyone. Every situation is unique and should depend on your circumstances: your income, financial security, plans and dreams for the future, intentions for your property, credit score, risk tolerance, and more.
Contacting a Jencor mortgage broker today can help ensure you understand what you are agreeing to, and that you are getting the best mortgage product for you!