Choosing Your Mortgage: Loan Types and How They Work

June 19, 2012

Purchasing a home is the largest investment most people will make in their lifetime. When it comes to taking out a mortgage on that major investment, it’s important to know what all the options are and to understand how the different types of mortgages work. Choosing the loan that will work best for you involves considering your risk tolerance and your plans for selling or refinancing, among other factors, with a clear understanding of how fixed and variable rate mortgages work.

Fixed Rate Mortgages

A fixed rate mortgage is precisely what it sounds like – your interest rate on the loan will remain the same for the duration of the term. So, if you accept a five-year fixed rate mortgage on your home, you will be paying that same rate for the next five years unless you sell the home or refinance it during that period of time.

Fixed rate mortgages offer a number of benefits for homeowners. The largest of these is that there is little risk involved. You will know from day one precisely how much your monthly mortgage payment will be, and that will not change over time. You will pay down the loan at a pre-determined rate and your interest charges stay the same for the duration of the term.

The prime rate set by The Bank of Canada, which impacts the mortgage rates charged by financial institutions, can fluctuate constantly. Hence, the best rate this week may no longer be available next week. Rates go up and down, so locking in at a low interest rate for a specified time frame can be a very smart call. On the other side of that coin, rates could drop and you could wind up locked into a higher rate.

Taking out a fixed rate mortgage requires taking a long view of the life of the mortgage, recognizing that rates will go up and down, but if you have done your homework and know that the rate you have locked in at is a good one, you can ride out the times when it’s lower knowing it evens out when rates are higher. There is of course the opportunity to refinance your fixed rate mortgage at some point in the future if interest rates drop. Bear in mind that there are usually costs associated with a refinance prior to the specified end date of the mortgage term. For this reason refinancing your loan is not usually something you want to do repeatedly, as the savings on the lower rate can become lost in the cost of the refinance.

Variable Rate Mortgages

A variable rate mortgage carries a little more risk than a fixed rate mortgage, because the interest rate fluctuates over time in harmony with the lender’s prime rate. Variable rate mortgages are based on the current prime rate plus a certain amount. As the prime rate changes, the amount of interest you are paying on your loan changes as well.

The amount of your payment will usually stay the same; but, the proportion that goes to the interest and the principle will fluctuate with the interest rate for the period of each payment. When the interest rate goes up the percentage of your payment allocated to paying down the principle mortgage amount decreases and vice versa. Occasionally, in times where there is a drastic change in the prime rate, the regular amount of the payment may not be sufficient to cover principal and interest, and your monthly payment could rise as a result.

This type of mortgage has the obvious benefit of being able to take advantage of low interest rates. On the other hand, if the prime rate rises, you could find yourself paying much more interest and not paying down the loan as quickly. And in the worst case, the payment on the mortgage could actually rise in response to interest rates.

Over the long term, the risk of this type of mortgage may be a little high for some homeowners; however, the rise and fall of interest rates over time does tend to even out. Also, keep in mind that most variable rate mortgages can be locked in at a fixed rate at any time without penalty.

Closed and Open Mortgages

Mortgages can be either closed or open, which determines whether or not there is a penalty for paying the mortgage off ahead of time. In an open mortgage, you have the freedom to pay off the full amount at any time without penalty. This is a good choice if you plan to sell the home within a short period of time or to refinance. Open mortgages are usually a short term with a higher interest rate.

A closed mortgage carries a penalty for paying off the balance before a certain set time period. This usually means you get a lower interest rate than an open mortgage and is an excellent choice for those with no plans to sell or refinance in the near future.

Other Mortgage Types

There are a variety of other types of mortgages available, each with its own purpose. A home equity mortgage is a type of mortgage that allows you to borrow against the equity in your home (the difference between what you owe and the market value). A convertible mortgage allows the buyer to switch from an adjustable rate to a fixed rate during a certain time period and is usually used when the buyer anticipates that interest rates will go down but wants to buy right away.

There are also multiple term mortgages which combine some different features into one loan. These are less common than either fixed or adjustable mortgage rates, which are the top mortgage choices. Additionally there are ‘hybrid’ mortgages available at most financial institutions that allow you to balance the pros and cons of each type of mortgage with a customized package.

Your mortgage is a personal choice, and the decision to select a certain type will depend on your circumstances and the current market. A mortgage expert can help you decide which choice is best for you.