The decision of whether to go with a fixed rate mortgage
or a variable rate mortgage
is one of the most complex ones in mortgage financing. It depends on various factors such as the person's risk tolerance, ability to absorb interest rate shock, anticipated changes in interest rates and personal preferences. Before we start to examine which mortgage type is best let's take a look at the differences between them.Fixed Rate Mortgage
A fixed rate mortgage is a mortgage with an interest rate that is guaranteed for the duration of the term. Regardless of what happens with the general level of interest rates in the economy, the mortgage rate for a fixed mortgage stays constant. Once the mortgage is up for renewal at the end of the term
it would have to be renewed at the prevailing rate at that point in time.
Fixed rates are affected by bond yields. Generally speaking a certain spread is maintained between bond yields and fixed mortgage rates so when bond yields increase so do fixed mortgage rates. Bond yields are influenced by economic factors (i.e. inflation, unemployment, etc.).Variable Rate Mortgage
A variable rate mortgage is a mortgage with an interest rate that fluctuates based on the prime lending rate. The prime lending rate is the rate used by banks to lend to their best customers. The prime rate is influenced by the key overnight rate set by the Bank of Canada. The key overnight rate is the rate at which banks make short term loans to each other and is adjusted based on economic factors.
The rate on a variable mortgage is set at prime plus/minus a discount or premium. For example it can be quoted as prime - 0.5% or prime + 0.2. If the prime rate increases during the term, your mortgage rate will increase. This will generally mean that a larger portion of your mortgage payment will go to pay off the interest and a smaller portion will go to pay off the principal. The opposite will be true when the prime rate decreases.Fixed vs. Variable - Which is Better?
This is a really hard question to answer. The rates on variable rate mortgages tend to be lower compared to fixed rate mortgages to compensate mortgagors for taking on the risk of interest rate fluctuations. When interest rates are expected to significantly increase, you might be better off with a fixed rate mortgage; in this case, locking in a fixed rate before rates (including variable mortgage rates) start to rise makes more sense. On the other hand if mortgage rates are expected to start falling you will likely be better off having a variable rate mortgage. Another factor is the spread between fixed and variable rates. If the spread between the two is small than the risk of going with a variable rate mortgage might not be worthwhile, and vice versa. The issue is that it is extremely difficult, if not impossible, to accurately predict interest rate movements and rates often reflect future rate expectations already.
According to CAAMP approximately 65% of mortgages are fixed rate. This would seem to contradict statistics that show that variable mortgage rates have generally been below fixed mortgage rates. In fact, a study conducted by York University finance professor Moshe Milevsky shows that people have saved money with a variable rate mortgage 89% of the time over fixed rates.
So why does the majority still prefer fixed mortgage rates? The answer probably has to do with risk tolerance. What if rates go up? Are you going to be able to absorb the interest rate shock? Canadians tend to be pretty risk averse and fixed mortgage rates tend to provide the peace of mind that the rate will not change for the duration of the term.