VRM? ARM? Fixed?

Variable, Adjustable or Fixed: What Type of Mortgage Should You Choose?

The question of which mortgage should you choose is central to the mortgage decision process, and will be a reflection of the type of borrower that you are. Variable and adjustable rate mortgages, although typically providing for cost savings over fixed, fluctuate and therefore may not be appropriate for the risk-adverse borrower. Fixed rate mortgages provide a comfort level over the term of the mortgage as you will know exactly what your payment will be throughout the term.

Variable, adjustable, and Invis’ own Market Direct Mortgage are based on the fluctuating Prime rate and Banker’s Acceptances respectively. For variable and adjustable rate mortgages, your interest rate will be Prime less a discounted rate depending on lender and product options. For Market Direct Mortgages, your interest rate will be the 30-day Banker’s Acceptance rate plus a set percentage (for more information on Market Direct Mortgages, please click here).

As you will see below, Prime Rate has typically been below the 5 year mortgage rate, which results in a considerable savings once the discount has been applied. Since 1951, there have been only a few points that Prime has equaled or been higher than the average 5 year rate.

The Prime Rate in Relation to Bond Yields

The following graph depicts Prime rate in relation to the yield on five year government benchmark bonds over five years from January 2000 to August 2005.

As stated above, actual pricing of a variable or adjustable rate mortgage will be Prime minus a discount percentage; actual pricing of a fixed rate mortgage will be bond yields plus a certain percentage. During periods of decreasing Prime rate, borrowers with variable or adjustable rate mortgages will benefit, whereas during periods of increasing Prime rate, how borrowers will fare will depend on the size of increases to Prime in relation to the fixed term rates available at the beginning of the term.

Other Considerations in Deciding on Variable/Adjustable vs. Fixed

While any tightening cycle by the Bank of Canada will tend to increase the advantage of holding a fixed rate mortgage, most variable and adjustable rate mortgage products have “lock-in” provisions which allow the mortgage holder to switch to a fixed rate product at any time during the term of the mortgage.

Some lenders offer low introductory interest rates for a set period, usually referred to as “teaser rates.” These offers are more significant for borrowers who will hold a mortgage for a shorter period of time.

Pre-payment penalties are another consideration for consumers deciding on which type of mortgage best meets their needs. Competitive variable and adjustable rate products typically have a pre-payment penalty amounting to 3 months – or even 2 months – of interest. Fixed rate mortgage penalties range from a minimum three months interest to the so-called Interest Rate Differential clauses that can amount to a sizable penalty. For homeowners planning to stay in their current home for less than five years, pre-payment penalty rules may factor into their mortgage decision.

Variable vs. Adjustable Rate Mortgages: Commonly spoken of in the same breadth, there are some acute differences between a variable and adjustable rate mortgage that may factor in to your decision-making process:

1. Variable rate mortgages are set at Prime less a discount, with the payment being set at either Prime less the discount or Prime. If you opt for the lower payment and Prime increases, your payments will also have to increase, however most variable rate mortgages do have a capped maximum rate. If you set your payments at Prime, and Prime does not increase greater than the discount, you will be paying down the principal of your mortgage faster.
   
   
2. Adjustable rate mortgages are also set at Prime less a discount, however, payments are based on that rate and pegged for usually a 90 day period, at which time they are pegged again for another 90 day period depending on what Prime is at that point. The good news is that if Prime decreases you will reap the benefit of a lower payment; however, if Prime increases, your payments will fluctuate and go up.

Risks / Benefits

	Variable / Adjustable	Fixed
Benefits	- Potentially significant interest savings - Ability to lock in to fixed rate.	- Comfort of known payment throughout term of mortgage. - If rates increase significantly, you are unaffected.
Risks	Fluctuating payments may make planning more difficult.	If rates decrease, you will be paying a higher rate.

Conclusions

Invis research suggests that the advantage of holding a fixed rate mortgage is greatest if a possible Bank of Canada tightening cycle were to happen relatively quickly – i.e. the Bank of Canada increases Prime substantially within a short period of time. If a tightening cycle is more gradual, there is a greater likelihood that holding a variable rate mortgage would be to one’s advantage given the history of interest rates.

With fixed rate mortgages, the homeowner knows with certainty the payments required over the term of the mortgage, providing a degree of comfort that is not available with variable rate mortgages. This certainty provides a measure of insurance against unexpected increases in short term interest rates. On the other hand, in most cases, short term interest rates would have to rise appreciably in order to diminish the attractiveness of a variable rate mortgage strategy. Regardless, expert guidance on the most advantageous mortgage strategy for you amidst changing interest rates, please seek advice from your Invis Mortgage Consultant.