Patricia Lovett-Reid

Canadians seem to talk about real estate almost as much as we talk about the weather. These days, it seems the talk has shifted from how much our homes are worth to how we are paying for them. Homeowners have long debated whether to opt for a floating rate or a fixed rate mortgage. The debate has taken on a new urgency as we emerge from the recession and face the prospect of rising interest rates.

Variable rate mortgages are based on your financial institution’s prime rate, which in turn, is closely linked to movement in the Bank of Canada’s overnight target rate. With the overnight rate sitting at a record low of 0.25 per cent, it has nowhere to go but up. In fact, TD Securities expects the first rate hike to occur at the July 20th meeting. They subsequently expect the rate to increase steadily, reaching 1.25 per cent by the end of 2010, and to continue to gradually tighten into 2011. You can expect variable mortgage rates to increase along the way.

But the overnight rate isn’t the only thing financial institutions examine when determining rates. Another factor is the yield curve. A normal yield curve is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time. Usually, the farther out on the yield curve, the higher the rate. You can see this quite clearly in the posted rates:

  • One year mortgages are posted at 3.65 per cent
  • Two years at 3.95 per cent
  • Three years at 4.70 per cent
  • Four years at 5.34 per cent and
  • Five years at 5.85 per cent

But that’s from the lender’s perspective. It still doesn’t make clear whether you should go fixed or variable. As I see it, when making the decision, you need to ask yourself one simple question: How well will I be able to sleep at night?

With a variable rate mortgage, your payments are fixed. They don’t change. But, what does change with interest rates is the allocation of your mortgage payment between principal and interest. If interest rates go down, more of the payment goes to principal. If interest rates go up, more of the payment goes toward the interest. With a fixed rate mortgage, your interest rate doesn’t change during the term of the mortgage. As time goes on, and you pay down the mortgage, more of the payment goes towards the principal and less goes to the interest.

If the rising trend in interest rates and the uncertainty of what your mortgage will cost you keeps you up at night, a fixed rate mortgage may be right for you, as it is much more predictable. There are no surprises and you know exactly how much is going to be left over at the end of your term. If you look at today’s rates, for a five-year fixed rate mortgage you’ll pay about a two to 2.5 per cent premium over a variable rate mortgage. You can think about this as an insurance policy that provides you with the peace of mind of not having to worry about the impact of interest rates for another five years.

However, if you’re not bothered by the prospect of a rise in rates, and are able to handle greater risk, a variable rate mortgage starts to look more and more appealing. The reason is simple: It could save you a significant amount of money. As per research done by Moshe Milevsky, associate professor of finance at the Schulich School of Business, from 1950 to 2007, the average Canadian could expect to save on interest 90.1 per cent of the time by choosing a variable rate mortgage instead of a fixed.

Keep in mind that we’re in a period of historically low interest rates and they are set to rise. There is no one-size-fits-all answer to the fixed vs. floating question. But if you can be honest with yourself in terms of risk tolerance, coming up with an answer can actually be quite easy.

So now that you’ve decided between variable and fixed, how do you actually get a mortgage?

The Canadian mortgage industry is a very competitive market and players are aggressive in trying to capitalize on this business. There are generally two methods of obtaining mortgage financing: directly through a bank/other mortgage lender or indirectly through a mortgage broker. Mortgage brokers have access to numerous lenders and can provide information on various lender offerings. They will shop around for attractive rates and terms for your mortgage. Often, the lending institution will be a major bank, trust company, credit union or other finance company.

In Canada, chartered banks finance more mortgages than all other lending institutions combined. Your bank advisor or specialist strives to provide a holistic solution that is optimal for you using their suite of financial products. By taking into consideration all outstanding debts, such as credit cards, loans, lines of credits, etc., as part of the overall solution, you may be able to improve cash flow and minimize your borrowing costs over the long-term.

Regardless of how you choose to obtain financing, there are a plethora of mortgage options out there to consider as not all mortgages are created equal, so it is important to do your homework. The interest rates are only one variable to take into consideration when deciding on your mortgage. Other factors to take into account include:

  • Terms of the mortgage — fixed vs. variable, open vs. closed
  • Amortization schedule — 25, 30 or 35 years
  • Prepayment allowance — How much and how often do they allow you to pre-pay every year before you are charged a penalty?
  • Frequency of payments — Which payment frequencyis most suitable for you? Weekly, bi-weekly, rapid bi-weekly, etc., and does the mortgagor allow for them?
  • Porting — If you move, can you port your mortgage, i.e. take your mortgage and term with you.
  • Assumption of terms — If you sell, can the buyer, subject to credit approval, assume your mortgage and rate?
  • Point of contact — Who can you call if you have a question or problem? For example, brokers may only arrange for the mortgage financing and have little involvement with the mortgage after it is financed. On the other hand, your bank already has a network of branches and call centers available to handle any inquiries.
  • Relationship — The relationship you have with your financial institutions may also prove to be beneficial when looking for approval and/or discussing interest rates.

The best piece of advice is to do your homework, shop around and ask many questions.