When it comes to purchasing a home in Canada, understanding the different types of mortgages available is important. There are a variety of mortgage options to suit different financial situations, preferences and ultimately, goals.
Below we’ll cover the basics of mortgage types, including fixed-rate and variable-rate mortgages, as well as other options like open, closed, and hybrid mortgages.
Fixed Rate Mortgages
The most popular choice among Canadian homebuyers is a fixed rate mortgage. With a fixed rate mortgage, the interest rate is locked in through your term, whether it’s a 1-year, 5-year, (or longer but that’s typically not recommended). This means that your monthly mortgage payments remain predictable and stable, which makes budgeting easier.
Predictable monthly payments
You’ll know exactly how much you need to pay every month.
Protection against interest rate hikes
Regardless of fluctuations in the market, your interest rate stays the same. This provides peace of mind in times of economic uncertainty.
Fixed rate mortgages are subject to the highest pre-payment penalties in the market. This is worth considering, as the majority of Canadians break their mortgage around 3 years into their term. This might not be on your radar when you buy your first home or at the start of a term, but it’s worthy of serious consideration and I’ll write more about it in future post.
Variable Rate Mortgages
In contrast, variable rate mortgages come with interest rates that can change periodically based on market conditions. These rates are tied to the prime rate set by your lender, which corresponds to the Bank of Canada’s overnight rate. Variable-rate mortgages often start with lower initial interest rates than fixed-rate mortgages, making them attractive to some buyers.
If interest rates remain low or decrease during your mortgage term, you could pay less interest compared to a fixed-rate mortgage.
Interest rate risk
Your monthly payments can fluctuate with changes in the prime rate, which can lead to budget uncertainty.
Variable rate mortgage penalties are often more favourable, since the dreaded IRD penalty never comes into play. Instead, the penalty to break a variable mortgage is 3 months of interest.
Closed mortgages are the more common choice for Canadian homebuyers. These mortgages come with certain restrictions on prepayment, such as annual lump-sum limits and pre-payment penalties for early repayment. But they have lower interest rates than open mortgages, sometimes considerably lower, which makes closed mortgages the most common for rate sensitive borrowers, and the obvious choice in most situations.
Lower interest rates
Closed mortgages generally come with lower interest rates compared to open mortgages.
Borrowers need to adhere to prepayment limits and will face a penalty for breaking the mortgage contract before the term ends.
Open mortgages offer ultimate flexibility in terms of prepayment options. You have the freedom to make additional payments or pay off the entire mortgage without incurring a penalty. This can be an advantage if you want the flexibility to pay large chunks of your mortgage in advance. For example, if you’re expecting to receive an inheritance or other large sum of money and want to use that to pay down your mortgage, or if you’re planning to sell your home in the near future.
A common open mortgage product is the Home Equity Line of Credit, or HELOC. This is a line of credit secured against a property. Although most people don’t know this (and why would you if you don’t live and breathe mortgages daily like I do), a HELOC is technically a mortgage (or in the case of combination products, a mortgage component). Any loan secured by property is technically a mortgage.
No prepayment penalties
You can completely pay off your mortgage early without facing extra costs. This makes an open mortgage the perfect option if you’re starting work late on your renewal and it makes sense to switch to a new lender – go into an open term for a week or two to bridge the gap. A higher rate for a few days is typically worth it for the long term savings.
Higher interest rates
Open mortgages come with higher interest rates compared to closed mortgages. Open mortgages can be 1-3% above their fixed rate counterparts.
Although not all that common, you could also consider a hybrid mortgage. This type of mortgage is divided into two parts: one with a fixed interest rate and another with a variable interest rate. This offers a middle-ground solution, providing some stability while still taking advantage of potential interest rate decreases and savings.
Hybrid mortgages allow borrowers to hedge against significant interest rate fluctuations by having a portion of the mortgage at a fixed rate.
You can still benefit from lower variable rates if they drop during your term.
Choosing the Right Mortgage for You
Selecting the right mortgage type depends on your financial situation, risk tolerance, and long-term goals. Here are some factors to consider:
- Financial Stability: If you prefer stable, predictable payments, a fixed-rate mortgage is the best option.
- Risk Tolerance: Variable-rate mortgages may offer potential cost savings but come with interest rate risk. Assess whether you’re comfortable with fluctuations to your rate and payment.
- Pre-payment: If you anticipate making very large (more than 20% of the mortgage balance) extra payments, an open mortgage or HELOC could be the best option, but remember that comes with a higher rate (often prime plus 0.5% to 1%).
- Hybrid Option: A hybrid mortgage can provide a balance between the stability of a fixed and and potential cost savings of a variable.
Remember that mortgage options vary between lenders, so it’s important to consult with a licensed mortgage professional to explore your options. We can help you find a mortgage with the features that best align with your financial goals and preferences. Explore your options and make an informed decision that suits your needs.
No matter which choice you make, you’re taking a risk. Make the choice that helps you feel confident that you stand the best chance of coming out ahead in the end. The interest rate landscape is always changing and no one has a crystal ball (unfortunately!). My commitment to you is to give you all of the most current info I have to help you make the right decision–and the “right” decision is always the one that best fits with your goals.