Do fixed mortgage rates provide better value than variable?

This article has been updated from a previous version.

At the last rate announcement in September, for the third consecutive time, the Bank of Canada (BoC) lowered its key interest rate by another 25 basis points, bringing the rate to 4.25%.

So, what does this mean for mortgage holders, or potential homebuyers? Does a fixed mortgage provide more value than a variable mortgage, or vice versa?

What do the recent rate cuts mean for fixed and mortgage rates now?

Presently, fixed mortgage rates remain stable, showing little to no immediate change in response to the rate cut. However, this stability is a temporary condition, as the potential for future reductions remains on the horizon.

Current five-year fixed mortgage rates already factor in the anticipation of a rate cut, marking the lowest rates seen since the onset of the previous tightening cycle.

This adjustment suggests that, should the BoC adopt a more aggressive stance with further cuts, there could be additional downward movement in these rates.

As for variable mortgages, the rate cut prompted big commercial banks to lower their prime rates, which are used to set the rates charged for variable-rate mortgages.

With the five-year variable rate now standing at 5.55%, a modest 25-basis point cut would not suffice to make variable rates as competitive as their fixed counterparts.

The current five-year fixed rate, hovering around 4.6%, may offer consumers a more attractive and stable option. Given these conditions, fixed rates present more value to consumers seeking to capitalize on the current market environment, providing both cost-effectiveness and predictability in an uncertain economic climate.

Read more: Mortgage rates are creeping closer to 4% after the latest inflation news

How do variable rates get priced?

Variable mortgage rates are closely tied to the prime rate, which is directly influenced by the Bank of Canada's policy rate. Think of the policy rate as the starting point or benchmark for many financial interest rates across the country.

When the BoC cuts its policy rate, it usually prompts a decrease in the prime rate. Mortgage lenders then use this prime rate as the baseline to determine variable mortgage rates.

They typically add a certain percentage, known as a "spread," to the prime rate to arrive at the final variable mortgage rate offered to consumers.

How do fixed rates get priced?

When the BoC changes its policy rate, it affects overall economic conditions and shapes investor expectations about the future.

These shifts can lead to changes in government bond yields, as investors adjust their strategies based on perceived economic stability and future interest rates. Since fixed mortgage rates are set based on these bond yields, a change in the policy rate can eventually impact the rates consumers pay on fixed mortgages.

Pros and cons of fixed-rate mortgages

Fixed-rate mortgages have long been favored by Canadians, and since late 2022, they’ve become even more appealing as their rates have dropped below those of variable mortgages.

This shift has led to an increase in lending under fixed-rate agreements, similar to trends seen before the pandemic. Borrowers are increasingly choosing fixed-rate terms ranging from one to five years. This preference is driven by expectations of future interest rate cuts and the small rate differences across various term lengths.

Benefits of choosing a fixed-rate mortgage

When deciding on the best mortgage option, understanding the pros and cons of fixed-rate mortgages can help you make informed decisions. Here are the main benefits for homebuyers.

Peace of mind and security

Fixed mortgages offer Canadians a sense of security, as they guarantee consistent monthly payments throughout the loan term. This predictability would allow you, as a homeowner, to budget effectively, eliminating any surprises from fluctuating interest rates for the term you’re locked in.

Competitive rates

With fixed mortgages, you can lock in a competitive interest rate for the entire duration of your term. This can be especially beneficial in a rising rate environment, providing you with protection against potential future rate hikes.

Related: What to do if your mortgage is up for renewal and you’re seeing an ugly interest rate?

Drawbacks of choosing a fixed rate mortgage

While variable rate mortgage-holders have been through the wringer of ballooning interest rates, there are reasons why fixed rate mortgages aren’t for everyone. Here are just a few.

Penalties for breaking your mortgage term

One of the significant drawbacks is the potential for hefty penalties if you decide to break your mortgage term early. This can happen if you choose to sell your home or refinance it before the term ends.

You’ll face a penalty based on the greater of three months' interest or the interest rate differential (IRD), which calculates the bank's loss using a comparison rate that varies by lender.

Less flexibility

Fixed mortgages tend to offer less flexibility compared to variable-rate options. Once your rate is locked, you're committed to that term length, which might not suit everyone's financial situation, especially if your personal circumstances change.

Potentially higher costs if rates drop

If interest rates decrease, homeowners with fixed mortgages might end up paying more compared to those with variable rates. This could lead to missed savings opportunities during periods of falling interest rates.

Three-year or five-year fixed terms?

When deciding between a 3-year and a 5-year fixed mortgage term, you’ll need to weigh several factors that can influence the value each option offers.

Currently, 3-year terms may offer slightly lower rates due to the shorter commitment period. This can be attractive to those anticipating a drop in rates, planning to refinance or sell their home within a few years.

The 5-year term, on the other hand, provides more stability and peace of mind with locked-in rates for a longer duration. Economic forecasts play a critical role in this decision. If analysts predict rising interest rates, securing a 5-year term could be wise to shield against future hikes. However, if a decrease is expected, a 3-year term might allow for refinancing at a lower rate sooner.

Canadians should also consider their personal financial situation and future plans. For those with stable jobs and no plans to move, a 5-year term might align better with their needs.

Ultimately, the decision hinges on balancing the desire for rate security with the potential benefits of future flexibility.

Pros and cons of variable-rate mortgages

Variable-rate mortgages gained popularity when the Bank slashed interest rates to nearly zero in 2020, making these loans cheaper and more appealing. Borrowers enjoyed lower costs, which spurred their popularity.

However, in 2022, as the BoC raised rates to tackle inflation, those with variable-rate loans faced increased costs. This resulted in higher monthly payments or longer loan terms to pay down the principal amount for many borrowers.

Related: $23,579: This is how much more a variable-rate could have cost homeowners over fixed-rate

Benefits of choosing a variable-rate mortgage

Here are some motivations behind choosing a variable mortgage:

Flexibility to benefit from falling rates

Variable mortgages offer the flexibility to capitalize on decreasing interest rates. As rates drop, your monthly payments could decrease as well, allowing you to save money or pay down your mortgage faster without having to refinance.

Lower penalties for early termination

Variable mortgages often come with more lenient terms if you need to break your mortgage early. The penalties are typically less severe than those associated with fixed mortgages, providing a financial cushion if you need to make significant life changes.

Drawback of choosing a variable-rate mortgage

Despite these benefits, it’s important not to underplay the main risk associated with variable mortgages.

Uncertainty with fluctuating payments

The biggest downside to variable mortgages is the uncertainty they bring. Monthly payments can fluctuate with changes in interest rates, making it hard to predict long-term costs and potentially leading to financial strain if rates increase unexpectedly.

If market interest rates rise, so will your mortgage payments. This can quickly escalate your monthly expenses, affecting your budget and financial plans. It's a risk that requires careful consideration, especially if economic conditions suggest potential rate hikes.

Three-year or five-year variable terms?

Deciding between a 3-year and a 5-year variable mortgage rate involves weighing flexibility against stability.

A 3-year variable rate is ideal for those expecting changes in their life or finances, as it offers the chance to reassess options sooner if rates rise.

In a 3-year variable mortgage, payments fluctuate with the prime rate, unlike a fixed rate, which remains constant but generally starts higher. Borrowers can choose between open or closed terms:

Closed variable mortgages: Lower rates but incur penalties if the contract is broken early.

Open variable mortgages: Higher rates but allow early repayment without penalties, offering flexibility for potential moves or refinancing.

Conversely, a 5-year variable rate suits those seeking a balance between flexibility and stability over a longer term. It may appeal to someone with moderate risk tolerance who anticipates that rate increases will be manageable, offering a more extended period without switching to a fixed rate.

Related: Can you negotiate your mortgage?

Should you get a fixed- or variable-rate mortgage?

While an easy answer would be nice, there’s no objectively right answer when it comes to picking your mortgage type.

Consider how likely it is you might sell your home within the next few years. If your job involves potential relocation or there's uncertainty about your future plans, opting for a shorter fixed term or a variable rate could be beneficial due to lower breakage penalties. Breaking a fixed-term mortgage, especially with major banks, can be costly.

Shorter-term fixed rates are generally cheaper but require more frequent renewals. So, assess your willingness to manage this process more often versus locking in a longer-term rate for convenience.

Understanding your capacity for risk is essential. If you have a higher risk tolerance, a variable mortgage might be appealing. For those who prefer certainty, a longer fixed rate might be better. With the current economic climate, it's crucial to consider where interest rates are headed.

Ultimately, your choice should align with your personal circumstances and financial goals. As a homeowner or first-time buyer, you should carefully manage their expectations about future rate changes and seek advice tailored to their specific situation.

Read next: What affects variable and fixed Canadian mortgage rates?