One of the most common questions mortgage shoppers have when they start their mortgage search is, "Should I go with either a fixed or variable rate?" The spread between fixed and variable mortgage rates fluctuates, and that spread is currently widening. So, which type of rate should you choose? And what's the difference between the two?
What are the differences between a fixed rate and variable rate mortgage?
A fixed mortgage rate enables you to “lock in” a predetermined rate for a set period of time (i.e. term). The most popular term in Canada is five years.
A fixed mortgage rate gives you a bit more comfort and security knowing what your monthly payments will be each month for the duration of your term. This makes financial planning and budgeting a lot easier. However, if interest rates go down during the time you're locked into a fixed rate term, you could miss out on potential savings.
A variable mortgage rate changes based on the mortgage lender’s prime rate. For example: if a lender is advertising a rate of -0.1 and prime is 3%, the rate would be 2.9%. In other words, your mortgage rate increases and decreases along with the prime rate.
Since prime can increase or decrease on a monthly basis, variable rates are not for the faint of heart. Anyone taking on a variable mortgage needs to be able to handle changes to their monthly payments not only financially, but psychologically as well — short-term savings may come with risk. If the thought of paying an extra $200 in mortgage payments causes you to lose sleep, a variable rate may not be for you.
What is "prime"?
Prime is the benchmark interest rate used by major banks when pricing for short term loans. Prime is directly influenced by the Bank of Canada (BOC)'s overnight lending rate and can fluctuate on a monthly basis. Changes to both the BOC’s overnight lending rate and the prime lending rate are determined by current economic conditions.
Over the last 25 years, the Bank of Canada has:
- Made changes to the prime lending rate an average of six times each year (directly affecting prime rates)
- Each change to the rate has been by either 0.25% or 0.50%
Fixed vs. variable: Which one is "better"?
A comparison of fixed vs. variable mortgages
Fixed vs. variable is one of the most important decisions when shopping for a mortgage. Here’s a quick summary of the main differences between these types of rates.
|Fixed rates||Variable rates|
|Definition||Allow you to lock in a rate for fixed period of time, the term of the mortgage||Fluctuates with the lenders Prime Interest Rate|
|Benefit||You know what your payments will be every month||Typically lower interest rate than with a fixed rate mortgage|
|Risk||You pay a premium for the security you get with a fixed rate in the form of higher interest rates||The fear of rising rates, which would increase your monthly payments|
|Affects||Government of Canada bond yield for the same term||The prime rate, which is ultimately affected by the Bank of Canada key overnight lending rate|
|Penalty to break contract||Lenders charge the greater of three months’ interest or an “interest rate differential” (IRD) which compensates them for interest lost as a result of you breaking your mortgage. This can get expensive||Three months’ interest|
|What has worked in the past?||Today’s economic environment is pretty unique, given that fixed mortgage rates are at all time lows. Many counties are still struggling to against high debt, increasing unemployment and a damaged housing market.||A study done by Dr. Moshe Milevsky, associate professor of finance, Schulich School of Business, York University,found that based on data from 1950 to 2007, the average Canadian could expect to save interest 90.1% of the time by choosing a variable-rate mortgage instead of a fixed rate. The average savings was $20,630 over 15 years per $100,000 borrowed.|
Should I always go with the lower rate?
The difference between the variable and fixed rates can be quite large, so is it always better to go with the lower rate?
Let’s compare a fixed rate of 3.99% vs. a variable rate of 2.05%, both on five-year terms. The interest difference between the two is 1.94%, so what would the difference in payments be? If we look at an average $250,000 mortgage amortized over 25 years, that turns out be a difference of $249.03/month, or $2,988.36/year.
Comparing a fixed rate to a variable rate is really like comparing apples to oranges. Security has a price (as does everything!), meaning you’re always going to pay a premium for the security of having a fixed mortgage rate. If having steady payments is important to you, think of it as buying a bit of insurance.
So, which one is “better”?
A few studies have been done in the past trying to figure out which option saves you the most money. The largest study was done by Dr. Moshe Milevsky, associate professor of finance at York University’s Schulich School of Business, using data from 1950 to 2007 (keep in mind that this also means that 10% of the time mortgage holders would have saved money by choosing a fixed rate mortgage).
The average Canadian would save 90.1% of the time by choosing a variable-rate mortgage instead of a fixed. The average savings was $20,630 over 15 years per $100,000 borrowed.
The bottom line? Security has a price (most of the time)
Variable rate mortgages have typically been a better choice for Canadians over the last 25 years and over the long run, homeowners can end up paying extra for a fixed rate — but this isn't always the case.
While the spread between fixed and variable rates is currently growing, it can sometimes narrow. And when it does, consumers find it increasingly difficult to gamble on a variable rate.
What's "better" in the end is a combination of your personal tolerance, and the current conditions in the mortgage market. If you're unsure on which would work better for you, it's best to talk to a mortgage expert who can help you determine which product will best suit your current needs.
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Engaging a mortgage broker before renewing can help you make a better decision. Mortgage brokers are an excellent source of information for deals specific to your area, contract terms, and their services require no out-of-pocket fees if you are well qualified.
Here at RATESDOTCA, we compare rates from the best Canadian mortgage brokers, major banks and dozens of smaller competitors.