Fixed vs. Variable Mortgage Rates

Can't decide between fixed vs variable mortgage rates? This quick guide looks at the pros and cons of fixed and variable mortgage rates.

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What is the difference between fixed and variable rates?

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.

What is a 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.).

What is a 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 or variable rate mortgage

This is often the most challenging decision for mortgage shoppers. In normal times, variable-rate mortgage rates tend to be lower compared to fixed-rate mortgages to compensate mortgagors for taking on the risk of interest-rate fluctuations. This wasn't the case during the latter half of 2020, when many fixed-rate terms could be found for less than variable-rate mortgages. When interest rates are reasonably expected to rise, you'd likely be better off with a fixed-rate mortgage. This can make sense if you're able to lock in a fixed rate before rates (including variable mortgage rates) start to rise. Unfortunately, not all lenders are competitive when quoting rates to floating-rate holders wanting to lock in a fixed rate. On the other hand, if mortgage rates are expected to fall, you're better off with 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.

Fixed vs. variable - which is better?

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.

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