Fixed vs. Variable (rate types)
As you look further into making your purchase decision, you’ll notice that there are some terms that are being thrown at you with which you may or may not be familiar. Typically, agents and brokers will use terms such as “fixed rate”, “variable rate”, and “protected (or capped) variable rate” to describe the types of interest rates available. As a potential buyer you should become familiar with these terms as making the rate choice can have a significant impact on your financial future. Included below are the basic definitions and explanations of each of these types.
A fixed rate means that your interest rate remains the same (fixed) for the entire term (duration) of the loan. Generally, this means the percentage of interest will be a little higher since the lending institution may be losing money in the future if the interest rates rise. A fixed rate loan provides the buyer with the serenity of knowing the cost of their interest will stay the same over time. This means your payment and the amount that goes towards reducing the principal (original loan amount) will remain the same over time as well.
A variable rate means the percentage of interest that you are repaying will vary based on the changes in the interest rate(s) of the overall market. Typically, fluctuations in your interest rate will not alter your monthly payment, but will vary the amount of your monthly payment that goes towards reducing your principal (original loan amount). This means if overall interest rates go down you will actually be paying off your loan more quickly. On the other hand, if interest rates increase, you will be paying off your loan more slowly. Accepting a variable rate does involve a certain amount of risk but can work to the advantage of the buyer over time.
Protected (Capped) Variable Rate
A protected variable rate is similar to the variable rate in that the interest rate will vary over time based on market fluctuations. The difference is that a maximum interest rate has been written into the loan contract so that if the market interest goes above a set percentage than the buyer only has to pay the agreed upon maximum. This minimizes some of the risk involved in a variable rate loan.
In addition to the standard choices listed above, some loans offer a convertible rate option that enables the buyer to change to a fixed rate without incurring any penalties. Many variable-rate and short-term fixed-rate loans are presented with a convertible option.
Making the right rate choice is going to be partially based on your own tolerance of risk as well as making careful analysis of the current and projected market changes. Ratesheet.ca provides an excellent decision tool to assist you in making a decision.