Your Mortgage: Variable vs Fixed Interest Rates

Check Out the Pros and Cons of Variable and Fixed Interest Rates to Decide Which Mortgage Is Best for You

Variable vs Fixed Rate Interest Rates

Buying a house is exciting, and you’ll doubtless be looking forward to planning all the details for your new home. One of the first decisions you’ll need to make is whether to opt for a variable or fixed rate mortgage. This isn’t always an easy decision, and even experienced home buyers can struggle to make up their minds. 

Luckily, we’re here to guide you through the pros and cons of each mortgage type. This way, you’ll have a better idea of which is best for you. Let’s start with a quick look at the differences between fixed interest rates and variable interest rates. From here, we’ll show you which mortgage type is more popular in Canada, especially amid the pandemic.

What Is a Fixed Interest Rate?

If you have a fixed interest rate, your mortgage payments will stay the same every month until you have completed your term. Many fixed rate mortgages have five-year terms, but others are longer. 

The Government of Canada’s bond yields determine your fixed rate at the time you take out your mortgage. Economic factors such as inflation, export, and unemployment drive these bond yields. Though bond yields fluctuate, your mortgage payments won’t. You’ll pay the same month in, month out.

What Is a Variable Interest Rate?

On the other hand, a variable interest rate fluctuates throughout your term. This means your mortgage payments will rise and fall each month. The economic factors that drive fixed rates also drive variable rates. However, variable rates also fluctuate in line with the Bank of Canada’s lenders’ Prime Rate. Usually, this rate increases when inflation is high and decreases when inflation is low. 

If you opt for a variable mortgage, you’ll pay a Prime Rate—plus a premium or minus a discount—depending on the market. The premium or discount relies on lenders’ desired market share, marketing strategies, competition, and credit market conditions. 

Usually, variable interest rates are a little lower than fixed interest rates because they are less risky for lenders. But this isn’t a guarantee.

Pros and Cons of Fixed Interest Rates

There’s only one main benefit to opting for a fixed interest rate, but it’s a big one. If you select a fixed mortgage, you won’t have to worry about unexpected costs popping up. You can be certain your rate won’t change, which can make budgeting easier. It’s this financial stability that convinces many first-time buyers to opt for a fixed rate when entering the mortgage space. 

However, if there’s a big difference between your variable and fixed rate options, it might not be worth paying a premium for the stability that a fixed interest rate offers. For example, if you opt for a fixed mortgage and the Prime Rate drops, you won’t be able to take advantage of interest savings. Of course, this does work both ways. If the Prime Rate increases, a fixed mortgage will protect you against the price hike. 

If you opt for a fixed rate mortgage and decide you’d like to switch to a variable rate mortgage, keep in mind that you might have to face financial penalties (unless you’re up for renewal). Take a look at your contract to find out what your penalties would be if you switched.

Pros and Cons of Variable Interest Rates

The main advantage of variable mortgages is that you may be able to save money if interest rates fall. Sometimes a variable rate will only be around 0.5% lower than a fixed rate (or lower again). But if you’re paying for your mortgage over a few decades, your savings could add up. 

Plus, most lenders don’t increase monthly payments significantly, even when mortgage rates increase. In this case, it’s more likely that a larger portion of your mortgage payment would cover the higher interest rate. The opposite usually applies when mortgage rates fall. 

It’s also reassuring to know that if your interest rate increases dramatically, you can switch to a fixed rate for the remainder of your term. It’s true that this fixed rate probably wouldn’t be as good as the fixed rate you were originally offered, and it’s likely you would incur an Interest Differential Penalty, but it could be worth the risk given the savings you could make with a variable mortgage rate. 

While these advantages can make variable mortgages tempting, it’s important to think about the financial uncertainty that comes with these mortgages, too. A significant increase in the Prime Rate will increase your interest payments, and you need to be aware of the potential price rises that you could face.

Are Variable or Fixed Interest Rates More Popular?

Stats show that the majority of home-owners opt for fixed interest rates. 74% of Canadian home-owners have fixed rate mortgages, 21% have variable rate mortgages, and 5% have hybrid mortgages. A hybrid mortgage is a blend of fixed and variable mortgages. You pay part of your loan at a fixed interest rate and the other part at a variable interest rate. As the stats show, they’re not very popular in Canada. 

In a nutshell, if interest rates are unlikely to fall in the near future, you’re probably better off with a fixed interest rate. But if interest rates are likely to fall, you might like to select the variable route. If the difference between the two is small, it’s usually safer to stick to the fixed rate. 

You might find it helpful to ask yourself the following questions when deciding which mortgage to choose. 

  • What kind of mortgage payment can I afford at the moment? 
  • If interest rates rise, will I still be able to afford a variable rate? 
  • How long do I plan to live in the new property? 
  • Which way are interest rates heading?

RateSpy founder Rob McLister explains that although you might save for a couple of years with a variable mortgage, you’re likely to see higher borrowing costs in later years. Therefore, variable mortgages are often only the better option for home-owners who are likely to pay off their mortgages early.

“Fixed rates are now so low that even a single quarter-point rate hike from the Bank of Canada—three to four years from now—could result in borrowers paying more interest in a variable than a five-year fixed,” says McLister.

How COVID-19 Has Affected Mortgage Rates

When the Prime Rate fell from 3.95% to 2.45% because of COVID-19 last March, thousands of home-owners took advantage of low variable mortgage rates. Many of these home-owners are still reaping the benefits now. However, the variable rates have lost their appeal for new borrowers as there’s barely any room for the rates to fall further. 

While COVID-19 continues to spread, we’re unlikely to see a major economic recovery any time soon. This means interest rates are likely to stay put for the foreseeable. As a result, some of Canada’s most competitive lenders are offering five-year fixed rates at less than 10 basis points above the lowest variable rates. 

“The premium between a variable rate mortgage and a fixed-rate mortgage is the price of ensuring that your rate will not go up over the next five years,” says True North Mortgage’s founder Dan Eisner. “That insurance is super cheap right now.” 

There isn’t much risk if you opt for a variable rate at the moment. But you’ll probably be better off on a fixed mortgage when inflation begins to grow again. 

Where Can I Get More Advice?

Whether you’re leaning towards a fixed or variable mortgage, we recommend reviewing your finances before making any final decisions. Should you need further help, Storey Collective can help you review your options and choose the best mortgage for you. 

Book your free phone consultation to discuss your financial situation and mortgage solutions.