Pros and Cons of Different Mortgage Types

Choosing the right mortgage product is one of the most important financial decisions a real estate investor will make. The type of mortgage you select can have a significant impact on your monthly cash flow, your total interest costs, and your overall investment strategy. In this post I will break down the most common mortgage types available to Canadian investors and explain the advantages and disadvantages of each.

Fixed Rate Mortgages

A fixed rate mortgage is exactly what it sounds like. The interest rate is locked in for the entire term of the mortgage, which in Canada is typically between one and five years. Your monthly payment remains the same throughout the term, regardless of what happens to interest rates in the broader economy.

The biggest advantage of a fixed rate mortgage is predictability. You know exactly what your mortgage payment will be each month for the entire term. This makes budgeting and cash flow projections straightforward and eliminates the risk of rising interest rates increasing your costs.

The disadvantage is that fixed rates are typically higher than variable rates at the time of origination. You are paying a premium for the security of a guaranteed rate. If interest rates decline during your term, you are stuck paying the higher fixed rate while borrowers with variable rate mortgages benefit from lower payments.

Fixed rate mortgages also tend to have more restrictive prepayment terms and higher penalties for breaking the mortgage early. This can be a significant drawback for investors who may want to refinance or sell the property before the term expires.

Variable Rate Mortgages

A variable rate mortgage has an interest rate that fluctuates based on the lender’s prime rate, which in turn is influenced by the Bank of Canada’s overnight rate. When interest rates go down, your mortgage rate goes down and your costs decrease. When rates go up, the opposite happens.

Historically, variable rate mortgages have tended to cost less over the long term compared to fixed rate mortgages. This is because borrowers are compensated for accepting the risk of rate fluctuations with a lower starting rate. However, this historical trend is not guaranteed to continue and there have been periods where variable rate borrowers paid more.

For real estate investors, variable rate mortgages offer several advantages beyond the potentially lower rate. They typically have lower penalties for early termination, which provides greater flexibility if you want to refinance or sell before the term expires. This flexibility is particularly valuable for investors executing strategies like BRRRR where refinancing is a planned step in the investment process.

The main disadvantage is the uncertainty. If interest rates rise significantly during your term, your costs can increase substantially. This can squeeze your cash flow and potentially turn a profitable property into a break even or negative cash flow situation.

Short Term vs. Long Term Mortgages

In Canada, the mortgage term refers to the length of time your interest rate and other contract terms are locked in. This is separate from the amortization period, which is the total time it takes to pay off the mortgage. Terms typically range from one to ten years, with five year terms being the most common.

Shorter terms of one to three years typically offer lower interest rates and provide the flexibility to renegotiate or refinance more frequently. This can be advantageous in a declining interest rate environment or for investors who plan to execute a value add strategy and refinance within a short timeframe.

Longer terms of five to ten years provide greater payment stability and protection against rising interest rates. For investors with a buy and hold strategy who value predictability above all else, a longer term can provide peace of mind and simplify long term financial planning.

The optimal term length depends on your investment strategy, your risk tolerance, and your view on the direction of interest rates. There is no universally right answer, and many successful investors use a mix of different terms across their portfolio to balance flexibility and stability.

Purchase Plus Improvements Mortgages

A purchase plus improvements mortgage is a specialized product that allows you to borrow additional funds above the purchase price to pay for renovations and improvements to the property. The total mortgage amount is based on the projected after improvement value of the property, not just the current purchase price.

This type of mortgage is extremely valuable for investors executing BRRRR or fix and flip strategies. It allows you to finance both the purchase and the renovations with a single mortgage product, reducing the need for additional financing and simplifying the overall transaction.

The approval process is more complex than a standard mortgage because the lender needs to evaluate both the current value and the projected post renovation value. You will typically need to provide detailed renovation plans and cost estimates. The funds for improvements are held back by the lender and released in stages as the work is completed and inspected.

Not all lenders offer purchase plus improvements mortgages, and the terms can vary significantly. A good mortgage broker who is familiar with this product type can help you find the right lender and navigate the approval process.

My Recommendations for Investors

For properties that I intend to hold long term with no planned refinancing, I generally prefer a five year fixed rate mortgage. The predictability it provides allows me to model cash flow projections with confidence and sleep well at night knowing that my costs are locked in.

For properties where I plan to execute a BRRRR strategy and refinance within one to three years, I prefer a variable rate or short term fixed rate mortgage. The lower penalties for early termination and the potentially lower interest rate align well with the shorter intended holding period.

Regardless of which mortgage type you choose, always work with a qualified mortgage broker who understands the needs of real estate investors. A good broker can present you with options from multiple lenders and help you select the product that best aligns with your specific investment strategy and risk tolerance.