Buying your first home can be an exhilarating experience, but also an exhausting one. After all that searching to find the perfect property, you have to figure out how to pay for it.
Generally, first-time home buyers use a mortgage to finance a property purchase. Not all mortgages are alike, however, and your choice can have significant implications on the size of your regular payment. In turn, this can impact the speed at which you are able to pay the mortgage off.
Mortgages can be broken down into two major types, fixed-rate and variable-rate. Here’s how they differ.
With a fixed-rate mortgage, both your interest rate and the size of your regular payment are guaranteed to stay the same for the full length of the term, usually five years but sometimes longer. You probably aren’t going to pay off all the principal in that period. Rather, it indicates the length of time before you renegotiate terms with your lender.
Fixed-rate mortgages provide certainty and stability, which can be important for risk-averse buyers, or those who don’t expect to earn significantly higher income in the future. By choosing a fixed-rate mortgage, you have the security of knowing for years in advance how much your regular mortgage payment will be, no matter what.
Variable-rate mortgages are sometimes called floating mortgages, because the interest rate floats in tandem with the lender’s prime rate. The prime rate is linked to two things: the yield on bonds, and the Bank of Canada’s overnight rate (the interest rate banks and major financial institutions pay when they borrow money from each other).
Variable rate mortgages are typically set at a premium above prime, or a discount below it. For instance, an example of a premium rate is prime plus 0.5 percent, while an example of a discount is prime minus 0.25 percent.
As interest rates rise and fall over time, so does the amount of your regular payment. When rates go down, you won’t have to pay as much. If rates rise, however, your mortgage payment will go up, too.
Variable-rate mortgages tend to have lower interest rates than fixed-rate mortgages, but they’re a riskier choice given the possibility of increasing payments. Some home buyers aren’t comfortable with the uncertainty of variable-rate mortgages, not knowing how their budget plans could be impacted by external factors.
How to choose
If interest rates are already low and aren’t expected to go much lower, a fixed-rate mortgage is generally best, because you’re insulated from the effect of rising rates. If rates are likely to decrease in the foreseeable future, a variable-rate mortgage will help you save on interest.
Financial certainty and security are often important to first-time home buyers, especially those who are starting a family. With a fixed-rate mortgage, you can lock in your rate and make budgeting decisions without the fear of having to pay more when rates rise.
If you’re considering a variable-rate mortgage, it’s a good idea to give yourself a personal stress test first. Calculate what your payment would rise to if interest rates climbed by two percent and determine whether you can handle that increase. If you can, a variable-rate mortgage could end up saving you some money, as interest rates have historically been lower for these products.
A final word
Think of the difference between fixed-rate and variable-rate mortgages as the cost of insurance against higher payments. For instance, if variable-rate mortgages are being offered at 3.0 percent and fixed-rate mortgages start at 3.5 percent, you’re paying an insurance premium of 0.5 percent to get the security of a fixed-rate for your entire term. With that knowledge, you can calculate the per payment or per year cost in dollars of that insurance, helping you better understand the price of each choice.