Choosing between a variable or fixed rate mortgage is one of the most significant decisions you will have to make when securing your mortgage. Although variable rate mortgages have historically provided more savings for borrowers, the peace of mind that comes with the cost certainty of a fixed rate mortgage may be more appealing to some (especially in an environment where interest rates are rising).
This blog will cover everything you need to know about fixed and variable rate mortgages, to help you make a decision on which mortgage option works best for you.
Here’s what we’ll be covering:
- What a variable rate mortgage is
- What a fixed rate mortgage is
- The pros and cons of each option
- Fixed vs. variable: what’s better?
- How to mitigate against rising rates with a variable mortgage
- When to switch from a variable rate to a fixed rate mortgage
- How a broker can help you decide what’s best for you
What Is A Variable Rate Mortgage?
As the name suggests, the interest rate of a variable rate mortgage can vary throughout the mortgage term. Your mortgage lender will offer a rate that is tied to their prime rate (usually the Bank of Canada’s Prime Rate).
So, let’s say the prime rate is 3.00%. If the lender offered you a variable rate of prime minus 0.50%, you would have an interest rate of 2.50%. If the prime rate were to jump up to 3.50%, your interest rate would also rise with it to 3.00%. If it were to fall to 2.50%, then your rate would also drop by the same amount to 2.00%.
A rising or falling rate will affect your monthly mortgage payment differently depending on whether you have an adjustable or variable rate mortgage.
Adjustable Rate Mortgage: Your mortgage payment will rise or fall with the interest rates. With this type of mortgage a steep rise in interest rates can make it tough to afford your mortgage payments.
Variable Rate Mortgage: Your regular payments remain the same even when rates rise or fall. What changes is the amount of your regular payment that goes toward paying the interest. The higher the rate, the more goes to paying off interest which means less will go toward paying off the actual loan (principal). This can cause your mortgage amortization to extend out further, taking you longer to pay back your mortgage in full.
Pros & Cons of Variable Rate Mortgages
Potential for lower costs: With a variable rate mortgage, you will pay less interest than a fixed rate mortgage if the rates remain the same or fall. Even if the rates rise, you may still be saving if they do not surpass the fixed rate amount.
Small break penalties: Breaking your variable rate mortgage will typically cost much less than breaking a fixed rate mortgage. If you were to break your variable rate mortgage contract, most lenders would only charge three months of interest.
High level of flexibility: Variable rate mortgages provide savings if interest rates drop during your mortgage term, while also allowing you to switch to a fixed term mortgage at any time if rates look like they are going to rise.
Higher risk: You will be rewarded by paying less interest than a fixed term mortgage if rates stay the same or decrease during your term. However, there is also the risk that you could end up paying more than you would with a fixed rate mortgage if rates rise.
Compounded more frequently: Compared to fixed rate mortgages that compound semi-annually, variable rate mortgages can compound either semi-annually or monthly. The more frequently your mortgage is compounded, the more interest you will pay.
Only three and five-year options are available: The only available term for a variable rate mortgage is three or five years. That said, you can switch to a fixed rate mortgage at any time, which has more available term options.
What is a Fixed Rate Mortgage?
With a fixed rate mortgage, you get exactly what you sign up for. The rate that you have to start your mortgage is locked in and will remain the same for the entire term. This means you’ll pay the same amount each month.
With a fixed rate mortgage, you are paying for the certainty that your rate will not rise over the course of your mortgage term ––this means fixed rate mortgage interest rates are typically higher than variable rate mortgages.
Pros and Cons of Fixed Rate Mortgages
Cost Certainty: With a fixed rate mortgage, you don’t have to worry about changing market conditions and rising interest rates. Your rate will remain the same over the course of your mortgage term.
Compounded Semi-annually: More frequent compounding means you pay more interest. Unlike variable rate mortgages that can compound monthly, fixed rate mortgages only compound semi-annually.
Higher early prepayment penalties: The penalties for breaking a fixed rate mortgage can be much higher than those for breaking a variable rate mortgage. Many lenders opt to charge penalties based on Interest Rate Differential (IRD), which can mean $1000s more than the three months of interest payments charged with variable rate mortgages.
**Pro Tip – not all lenders calculate the IRD the same way. Some lenders have penalties that are 3x higher than others. Your mortgage agent can help you find a lender with more favourable prepayment penalties based on your needs.
Restrictive: With a fixed rate mortgage, you are locked in for the entire term unless you are willing to pay potentially hefty penalties. This means you won’t be able to refinance to take advantage of falling rates should that occur.
The Different Fixed Rate Mortgage Terms
Unlike a variable rate mortgage with only three and five-year terms, fixed rate mortgages have various term options of 6 months, up to 10 years, depending on the lender. The most popular fixed rate mortgage in Canada is 5 years, but it’s not always the best option for everyone. When choosing what term is best for you, there are some important factors to consider.
Interest Rates: A longer fixed rate mortgage term typically means a higher interest rate, as you are paying for cost certainty over an extended period.
Cost to break your mortgage: Breaking a fixed rate mortgage mid-contract can be very expensive. Unless you are 100% sure that you will remain in your home for the course of your mortgage term (for example, 5 years), then a shorter term may be the best option for you.
Amount of work: Another factor to consider is the amount of time and effort that goes into remortgaging. Shorter terms mean more frequent remortgaging.
Fixed vs. Variable Rate Mortgage: What’s The Better Choice?
The answer to this question will vary depending on who’s asking and what’s going on in the market at the time. Your best bet is to consult with a mortgage agent. They will be able to identify the best option for you by considering the following factors:
- Your aversion to risk, i.e., is your income stable? Can you easily manage a higher payment?
- How long do you plan on living at your home?
- The current state of the market.
- Past, current, and potential mortgage trends.
How to Mitigate Risk When Choosing a Variable Rate: Hedging Strategies
An effective way to hedge against the risk of increasing interest rates when you have a variable rate mortgage is to take advantage of the prepayment privileges. An excellent way to do this is to increase your monthly mortgage payment to match the higher amount it would cost if you had chosen a fixed rate mortgage.
Let’s take a look at an example:
5 Year Fixed rate 5.00%
Mortgage amount: $500,000
Amortization Period: 25 Years
Monthly Payment: $2,908
Variable rate 3.00%
Mortgage Amount $500,000
Amortization Period: 25 Years
Monthly Payment: $2,366
When you make a lump sum payment or increase your monthly payment, that extra amount goes directly to interest. So by increasing your payments by $542 to $2,908 (fixed rate amount), you will be taking advantage of your lower rate to get ahead on payments. If rates do not increase, you will simply be able to pay off your mortgage faster, saving potentially thousands of dollars. If rates do increase to a point where your variable rate is higher than the fixed rate, you will have effectively mitigated the risk, as it will still take a fair amount of time for you to end up paying more than you would have if you had gone with a fixed rate.
When to Move a Variable Into a Fixed Rate
So, when should you switch from your variable rate mortgage over to a fixed rate? Well, that will depend on your financial picture, and aversion to risk. If looming interest rate increases will make it difficult to pay off your debt then the security that comes with locking in your rate with a fixed rate mortgage may be your best option. However, even if your variable rate ends up jumping above the 5 year fixed rate you may still come out ahead, as you will only be giving back some of the savings you accumulated earlier in the mortgage term when the variable rate was lower.
Ultimately, there is no one size fits all answer to this question. Be sure you are making an informed decision by discussing your options with a mortgage broker before making the switch!
How a Broker Can Help You Decide What’s Best For You
As you can see, there is a lot to consider when deciding between a fixed rate or variable rate mortgage. With thousands of dollars in potential savings in the balance, your best bet is to lean on an expert for help. At Pineapple, our skilled mortgage agents can work with you to determine your best option. We can help you work through:
- Making the right choice for you, depending on your situation
- Your appetite for risk and how that can inform your decision
- The best mortgage products to meet your specific needs
- Considerations based on market conditions and mortgage trends
- Much more
If you have more questions about fixed vs.variable rate mortgages, or you want to get started on your home buying journey, give us a call today!