You have everything in place.
Down payment money? Check.
Money set aside for closing costs? Check.
Then you see it. Your forever home. Gorgeous. Four bedrooms. Quiet street.
Your offer is accepted, and excitement and joy overcome you.
The next day, you are talking to your mortgage broker and you have a question. How do you choose between a fixed rate vs. variable rate mortgage?
If you’re like most Canadians (74%), you’ll likely opt for a fixed-rate mortgage, according to a Mortgage Professionals Canada 2022 report.
Canadians don’t give too much thought to the type of mortgage they want. After all, a mortgage is just a necessary tool you need in order to get what you really want, your house.
However, there are factors you should consider when making this decision as it could cost you tens of thousands of dollars if you’re not careful.
This article will explain the difference between fixed and variable mortgages and touch on six factors that you should keep in mind when selecting the right mortgage type for you and your family.
Let’s explore what fixed and variable mortgages are first.
- Fixed-Rate Mortgages
- Variable Rate Mortgages
- Mortgage Type: Factors that Influence Your Decision
- Shorter Term Fixed Rate Mortgage vs.Variable Rate Mortgage?
- Fixed Rate vs Variable Rate Mortgage Conclusion
- Fixed Rate vs Variable Rate Mortgage FAQs
If you have a fixed-rate mortgage (FRM) you will get a mortgage with a pre-determined interest rate for a set period (called a “term”). Your mortgage payments will remain the same all throughout your term.
If you agree to an interest rate of 2.25% and a monthly payment of $2,000, then that’s how much you pay whether you’re in month 1, 32 or month 60 of the term.
You can take a mortgage term of anywhere between 6 months and 10 years, although most people get a five-year mortgage in Canada.
Variable Rate Mortgages
The Bank of Canada (BoC) influences variable rate mortgages when they set their Prime Lending Rate.
The Bank of Canada Prime Lending Rate affects your lender’s rate, so if the BoC raises rates, your lender will probably raise their rates too. If the BoC lowers rates then guess what will happen?
Yes, your lender will lower their interest rates too.
There are actually two similar mortgage types that fall into this category of being influenced by the Bank of Canada’s prime lending rate: variable rate mortgages (VRMs) and adjustable rate mortgages (ARMs).
1. Variable Rate Mortgage (VRM): With a variable rate mortgage, if the BoC increases its interest rates, your mortgage interest rate will climb as well.
However, your monthly mortgage payment amount will stay the exact same.
With a true VRM, if your monthly payment was $1,500 prior to a rate change (up or down), it will continue to be $1,500 after the interest rate change.
What changes is the proportion of your monthly mortgage payment that is assigned to the principal versus the interest.
When the interest rates rise, less of your mortgage payments will go towards principal and more will be redirected to paying down interest than before.
Your amortization will increase slightly, as it will take you longer to pay off your mortgage because you are paying less principal than before.
The opposite is true too, though.
Suppose interest rates fall.
While your total monthly mortgage payment stays the same, more of your mortgage payment will go towards paying off your principal than before and it will take you less time to pay down your mortgage. Therefore, your amortization period will decrease.
2. Adjustable Rate Mortgage (ARM): If the BoC increases its interest rates, your interest rate will climb and so too will your mortgage payment. That last part is the major difference between a VRM and an ARM.
As interest rates change, so do your monthly mortgage payment amounts.
If you were paying $1,500 per month for a mortgage and your lender raised the interest rate, your monthly payments would rise (let’s say to $1,525 per month).
If the interest rates dropped, then you might only need to pay $1,475 for your next mortgage payment. Again, your monthly mortgage payment amounts fluctuate with the changes in your lender’s interest rates under this type of mortgage.
The terms variable and adjustable rate mortgages are often used interchangeably so be sure to ask your lender about what happens to your monthly (or weekly, semi-monthly etc.) mortgage payment amount when interest rates change. That way, there will be no surprises.
Now that the definitions are in the books, let’s see which factors can influence the type of mortgage you select.
Mortgage Type: Factors that Influence Your Decision
1. Psychological / Emotional Makeup
The thought of your mortgage payment increasing mid-term may not be something you can handle. If that is the case, then a fixed-rate mortgage that allows you to keep your payments the same throughout the life of the term may be the better product.
Morgan Housel and other behavioural financial experts often talk about choosing the option that helps you sleep at night. There is no point in doing something financially that will stress you out so much that your mental and physical health will suffer from it.
Keep in mind, that the Bank of Canada meets eight times a year to decide what to do with the interest rate as it relates to monetary policy. At these meetings, they discuss whether they should increase, decrease or keep interest rates the same for the betterment of the Canadian economy.
If you are going to experience heightened levels of anxiety before every BoC meeting, then a variable rate mortgage is not for you.
If you are risk-averse or if you can get a variable interest rate at a steep discount compared to the prevailing fixed interest rate, then you may feel very comfortable going the variable route.
Fixed rates have minimal flexibility. If interest rates drop after you sign a mortgage contract, you are still stuck at a higher rate. You need to weigh the benefit of a refinance (breaking your contract to receive a lower interest rate) with the penalty fee for breaking the contract.
If interest rates rise and you have a lower, locked-in fixed rate, then you’ll feel great about your decision.
Variable rate mortgages offer you a lot more flexibility because you have more options. Even if you start with a variable mortgage, you can usually convert to a fixed mortgage rate at a later date.
The fixed rate you negotiate at that later date will inevitably be higher than the one you would have received when you first negotiated your mortgage though.
3. Mortgage Penalty Fees
When breaking a mortgage contract, you always have to pay a fee if you have a closed mortgage.
Variable rate mortgages generally have cancellation penalties of three months of interest. This is extremely cheap compared to penalties for fixed-rate mortgages, especially through the big banks.
Fixed-rate mortgage penalties are calculated based on the interest rate differential (IRD) or three months interest, whichever is higher. The IRD can cost a significant amount of money, sometimes tens of thousands of dollars.
Most Canadians choose a five-year fixed-rate mortgage. However, a good portion of Canadians break their mortgage contract. That results in huge penalties if you have a fixed-rate mortgage.
A lot of borrowers solely focus on getting the lowest mortgage rate and little thought is given to mortgage cancellation penalties.
You may think that you will see out your five-year term.
That may or may not happen and the reason is…. life. A lot of life events happen right around the time you get your first or second mortgage.
So what could make you break your mortgage contract? Well, you might….
- Need to change employers or work locations as you move through your career. This may require changing cities. If your work is now offered remotely, then you can move farther away than you previously imagined.
- Get married. You may decide to pool your resources and buy a brand new place. If you need to sell your current condo to buy a home with your partner, then you will probably need to break your contract.
- Have kids. Once you do, you’ll find that your one bed plus a den condo is no longer big enough.
- Relocate. You might move to the suburbs to find cheaper housing.
- Lose your job. If you don’t have an emergency fund, you may need to refinance the house.
- Experience lifestyle creep. As you earn money, you might want to move into a bigger house just because all your friends are doing it.
As you can see, there are many reasons you may need to break your mortgage contract.
While finding the lowest rate makes financial sense, it may not align with your life goals and that’s why a variable rate mortgage and its relatively inexpensive penalty fees may make more sense.
One additional way you can cut down on fixed-rate penalties for breaking your mortgage is to use a fair penalty lender such as a monoline lender that can be found via a mortgage broker. These types of lenders have much lower fixed rate penalties than the big banks.
4. Money Management
The more fixed costs you have, the easier it is for you to keep track of costs for your budget. This makes a fixed-rate mortgage desirable.
You will always know what your monthly payment will be for the duration of your mortgage term. In an era where food, home and transport costs are increasing you may want a cost like this to remain stable.
If you are retired and living on a fixed income from government pensions, then you may appreciate the reliability of a fixed-rate mortgage payment.
With variable rate mortgages, you can find yourself with higher or lower monthly payments than you started with originally because of interest rates increasing or decreasing. It is more difficult to manage your money if you don’t know what your expenses are each month.
5. Macro Environment
If the economy is doing well, then interest rates will likely rise because the government doesn’t need to stimulate spending anymore and will want to temper everyone’s bullish behaviour. People won’t need the same low rate incentive to borrow if they have jobs and are making money.
If the economy is sputtering, then governments typically lower the interest rate to make the price of borrowing cheaper.
If you and your friends can finance a car and a house for 1% less than you were before, then you would likely spend more money. This increased spending helps the economy rebound.
The Bank of Canada in March and April 2022 began aggressively increasing interest rates to combat extremely high rates of inflation. Both fixed and variable interest rates have skyrocketed.
No one really knows which way the interest rates will go from here. We have an idea, but external factors can pop up out of nowhere and the Bank of Canada can choose to reverse or accelerate their course of action a moment’s notice.
6. Historical Data
Variable mortgage rates have generally been lower than fixed mortgage rates for the better part of the 2000s. Variable rates offer a lower initial interest rate to reward borrowers because their future monthly payments are unknown.
When the variable rate differs (known as the “spread”) from the fixed mortgage rate by 0.50% (known as 50 basis points) or more, then you are in pretty good shape if you choose to go with a variable rate mortgage.
The BoC typically raises interest rates 25 basis points (0.25%) at a time, meaning you would need two rate increases to go back to an “even rate” with the fixed-rate level you would have been offered when you negotiated your current mortgage rate.
However, you would still be financially ahead because you had a length of time where you had a lower mortgage rate than a fixed mortgage, so it would likely take you at least one or two more rate increases before you would have been better off taking a fixed mortgage from a purely financial perspective.
As rates have mostly fallen over the past few decades, you would have been better off with a variable rate mortgage. In the last few years, interest rates have hit new historically low levels and as mentioned before, the Bank of Canada is agressively raising rates.
If you looked at the historical data, you may have anticipated a mortgage rate reversal, or maybe you would expect the cheap debt to continue.
While you can look at the historical and/or macro data, no one truly knows what will happen to mortgage rates in the future.
The best thing to do is stress test yourself at much higher interest rates. Use the Government of Canada’s mortgage calculator and put interest rates in that are 2% higher. With your hypothetical new mortgage payment in hand, can you still manage your budget and live life without going into debt?
Or would you have to cut back on some expenses? Be honest, and then plan in advance so you can figure out how to save more money.
Shorter Term Fixed Rate Mortgage vs.Variable Rate Mortgage?
With mortgages, you can really gain ground when you think outside of the box. Sometimes a two or three-year fixed-rate mortgage can be had for a steep discount off the 5 year fixed rate.
You might not match the low five-year variable rate but you can opt to take two fixed year terms (say a three-year fixed-rate term followed by a two-year fixed-rate term) instead of a 5-year variable rate.
Maybe your reasons are not even financial. Perhaps you just want the option of a shorter term because you expect to sell your current house in two or three years and you don’t want to be tied down with a particular lender.
Also, by taking two shorter fixed terms instead of one longer fixed term, you keep your potential fixed-rate penalties lower if you need to break your mortgage early because part of the interest rate differential (IRD) calculation depends on the number of years left. The fewer years you have left in your mortgage, the smaller penalty you pay.
Of course if interest rates are significantly higher after your initial two-year term, you may be kicking yourself for not taking a four or five-year fixed rate mortgage.
Fixed Rate vs Variable Rate Mortgage Conclusion
You learned in this article that there are many factors that influence the type of mortgage you ultimately choose.
Your psychological makeup, risk profile, your desire for flexibility, estimated mortgage penalty fees, household money situation and the macro environment all contribute to your decision.
If you are up for a mortgage renewal soon, what type of mortgage would you likely take and why? Leave us a comment in the section below.
Fixed Rate vs Variable Rate Mortgage FAQs
What is the greatest advantage of a fixed-rate mortgage?
The biggest benefit of having a fixed-rate mortgage is that your costs will always be the same throughout the mortgage term, no matter whether interest rates rise or fall. From an economic standpoint, it helps you stick to your budget. From an emotional standpoint, you don’t have to stress at night wondering whether you’ll have to pay more next month.
Do variable mortgage rates increase?
Sometimes variable mortgage rates do increase because the Bank of Canada may decide to increase the Prime Lending Rate.
Depending on the type of mortgage you have though, your dollar amount may or may not change.
If you have an adjustable-rate mortgage, your lender will increase your mortgage payment amount during the term if the Bank of Canada increases rates.
If you have a true variable rate mortgage, your mortgage payments remain the same. Although more of your mortgage payment is redirected towards interest rather than principal.
Here are some important mortgage articles to check out.