Fixed rate/ Variable rate with constant payment / Adjustable-rate mortgage
Fixed rate:
Payments are locked in and will not change within the term of your mortgage. Your payment includes capital+ interest.
Benefits: security and client can budget accordingly
Risks: potential lack of savings ( client may not save as much interest as possible during the term if variable rates are low/ decrease )
potential type of client: first-time home buyer , client on tied budget, risk averse client.
Variable rate with constant payment:
Rate can fluctuate with time (decrease or increase) but the monthly payment is fixed. If the rate goes up for instance, then the portion going toward interest (rather than principal) increases.
Benefits: potential saving as is most cases variable rate tends to be lower than fixed rate. If rate decreases, then more of their payments will go toward capital (rather than into interest). The ability to switch to a fixed rate through the same lender without penalty.
Risks: As rate increases more money goes toward interest and less money to capital, which will extend the amortization to be able to pay the mortgage in full. Also, if the rate increases substantially, the client may reach a point where their fixed payments will only cover interest and not any principal (trigger point) and they will have to increase their payments to be able to cover the additional amount of interest and capital, which can cause a negative amortization. This payment increase for some households might be unexpected and they may not be able to sustain the payments increase.
Potential type of client: client with reasonable cash value into their house, client that can tolerate some risk, client that wants to pay off his mortgage quickly.
Adjustable-rate mortgage:
Your mortgage rate is fluctuating and your mortgage payments will change when the interest rates change. If the rates increase, your payments will also increase (opposite is true as well ).
Benefits: Potential saving if rates are low or decrease, which will improve the client ‘s cash flow. You also keep the same amortization as originally. Clients can switch to a fixed rate if the situation warrants it.
Risks: volatility as the rates can increase substantially, which will cause payments fluctuation and the result will be a cash flow uncertainty for the client. Some clients will use credit to compensate for the loss of their cash flow for their day to day obligation , which can result in the client being more indebted or force them to sell their house.
Potential type of client: Investors, clients knowing they will not keep the mortgage for a long time, clients who are not risk sensitive.
Case study: house 500000$, monthly payment , simple interest, initial amortization 25 years.
Fixed rate: interest 3%, monthly payment 2366.23$, interest paid for the first year 14650$, capital reimbursed 13745$
Variable rate with constant payment: interest increases to 4%, but payment stays constant at 2366.23$/month. Now the interest paid the first-year changes to 19582$ and the capital reimbursed to 8812$. New amortization increases to 31.07 years instead of 25 years initially.
Potential solution will be to either make lump sum payments or increase the mortgage payments to be able to pay back the mortgage in full within 25 years.
Adjustable-rate mortgage (ARM): interest increases to 4%, so does the mortgage payments. New monthly payment is 2630.10$, amortization stays at 25 years. Interest paid the first year 19514$ and capital reimbursed the first year is 12048$.
We can see that with the adjustable-rate, the monthly payment has increased from 2366.32$ to 2630.10$, which means a monthly cash flow decrease of 263.78$. That’s only for one increase. Imagine multiple rate increases like we have had the last 8 months with the Bank of Canada, and we can understand why more households have high debt ratios.