One of THE most common questions we get is "Should I go fixed or variable?"
Let’s break it down. There are actually 2 bets you’re making - the rate and the mortgage penalty. Let us explain!
What’s the better rate?
In general, variable rate tends to be lower than fixed rate. Some of you may be scared of what happens if prime rate increases so you may prefer to choose fixed rate. On the other hand, some of you may be ok with rate changes and just want the best rate, so you'd prefer to choose variable.
Here’s an example to think about: If variable rate is 2% and fixed rate is 2.50%, most people would hope that their variable rate never goes to 2.75% because that'd be paying more than if fixed but that's actually the incorrect way of thinking. What you should be hoping for is that the rate doesn't go above 3%. Why? Because you haven't accounted for the amount you saved when rates were between 2%-2.5%. Once you've passed 2.5%, you're actually just using the savings you had from before but once you hit 3%, that's when you start to break even. If you look at the prime rate history, rarely do rates go up that quickly.
Then there's the mortgage penalty.
What actually happens if you break the mortgage early? You may be thinking that you most likely won't break the mortgage early and that this is irrelevant for you. "Sign up for 5 years, stay for 5 years". However, statistics show that 2/3 people break their mortgage within 33 months or just about 3 years. Life happens - you get a new job and need to move, your family grows, you've lost your job and need to sell your home, and so on. So many things can happen and banks know this so they take advantage of it. A good portion of what banks make are from penalties.
Let's go through an example together.
The average mortgage size is $400,000. If you had a 5 yr fixed rate, your penalty is calculated by the interest rate differential. That’s a complicated formula but in general, it’s around 4.5% of the mortgage balance. On a $400,000 mortgage, that’s about $18,000.
But for a variable, it’s different. The penalty is capped at 3 months interest penalty. Some banks calculate the rate at prime or at contract rate. For the purpose of this example, we're going to use the prime rate at 2.45% because it’s higher to better prove our point. The 3 months interest on a $400,000 mortgage at 2.45% is only $2,450. That's what would be your penalty!
That is a $15,550 difference! Most people wouldn't have thought about this because they're focused on the rate changes, but banks get you at the end of the mortgage because you can't time the sale of your property exactly on the date your mortgage matures.
This is why we recommend variable for most cases. Don’t be afraid of the rate fluctuating. Be more afraid of the penalty you get hit at the end when you pay out the mortgage.
If you have any questions, please don't hesitate to reach out and ask us! We're here to help.