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29 Feb

Fixed, Variable, Closed, Open

General

Posted by: Gleb Tchani

Many of you may be aware of the differences, but I often come across this confusion, so I would like to clarify on what each of these mean.  Fixed and Variable are conditions that describe the interest rate on the mortgage, while Closed and Open describe the type of contract you are entering.  Also, I will add a quick note on what is a Term and what is an Amortization.

Variable Rate – this is a form of a mortgage interest rate that is determined by the Prime Rate, which in turn is set, based on the Overnight Lending Rate set by the Bank of Canada.  The Overnight Lending Rate is a government tool that is reviewed on quarterly bases to move toward a specified economic goal.  You can find more information, including future meeting dates, on the Bank of Canada website at the following link.  A change in Overnight Lending Rate, typically, triggers change in Prime Rate and, since there is a potential of change at any given quarter, the said rate is referred to as variable.

Example:

Today, February of 2016, you are able to obtain a Prime – 0.55%.  Current Overnight Lending Rate is 0.50% and current Prime Rate is 2.70% so the rate you are able to obtain is Prime – 0.55% = 2.70% – 0.55% = 2.15%.  Next Bank of Canada meeting for interest rate announcement is set at March 9th.  Let’s assume the overnight lending rate gets increased by 0.25% to 0.75%.  This move will likely be followed by banks increasing their Prime rate by the same increment of 0.25% to 2.95%.  The new Prime Rate will change your contract rate to Prime – 0.55% = 2.95% – 0.55% = 2.40%.

 

Fixed Rate – this rate remains fixed through the duration (term) of your contract.  No matter what happens with the economy and/or the market, you will continue your mortgage contract with the specified rate.  We all understand that, in the long run, it is more likely that the rates will increase.  Fixed mortgage rates offer us, the clients, a peace of mind.  For that reason, lenders will typically offer a slightly higher fixed rate over the variable rate.

Closed Term Mortgage – closed term mortgages are mortgage contracts where we are locked in to all conditions of the contract for the term of the contract.  One of these conditions is inability to repay the mortgage ahead of time.  This is important to the lenders because their income is determined by us, clients, continuing to hold a mortgage loan and hence, paying interest.  Because this feature is beneficial to the lender, we as clients are able to obtain a better rate that way.  Mortgage penalty is a very important issue that often comes up and is a result of breaking a closed term mortgage.  This details of mortgage penalties require a separate article that I will get to in the near future.

Open Term Mortgage – on the other hand, an open term mortgage allows us to repay full balance at any time.  Early prepayment actually has a negative impact on the lender as they are expecting us to pay interest over a certain period of time.  Since it is not beneficial to the lender, the open term mortgages rates are usually higher.

Term vs Amortization – both of these describe length of time and just to help you avoid confusion, Term is the length of current contract, where Amortization is the total amount of time it would take to repay a mortgage.  The length of amortization is one of the factors that determines amount of your payments.  That is why, even though you may be signing a contract for just 5 years, it is important to know what the amortization period is.  At the end of the term, you have an option to repay the remaining balance or make another arrangement for a mortgage loan.  If you do not refinance and simply switch to another lender, you now have a new mortgage contract for a new term, but with only the remainder of your amortization period.

Have any more questions?  Do not hesitate to contact me, I would be very happy to help.