Are Variable Mortgage Rates Still the Best Bet?

Interest rates have been in the news lately, in Canada and around the world. The U.S. Federal reserve has been raising rates, the Bank of England recently raised its key interest rate for the just the second time in the last 10 years, and the Bank of Canada has been raising its rates as well.

When it comes to mortgages, Canadians have the privilege of locking in a fixed mortgage rate for up to five years. But during the economic recovery of the last decade, there wasn’t much threat of a rate hike, making variable-rate mortgages particularly attractive.

So, now that rates are going up, are variable-rate mortgages still the best option?

Related Read: The BoC Holds Rate in September Announcement

What’s in a Mortgage Rate?

When you sign up for a new mortgage, you have a decision to make: fixed or variable.

Fixed-rate mortgages don’t change over the term (usually five years). No matter what goes on in the economy or with interest rates, your mortgage contract is set. Your payment won’t go up or down.

Variable-rate mortgages change relative to your lender’s prime rate, which is based on the Bank of Canada’s key interest rate. When rates go down, you pay less; when rates go up, you pay more.

Variable-rate mortgages usually have much lower rates than their fixed-rate counterparts at origination. For example, today’s best rate for a 5-year fixed mortgage is 3.14 per cent. The best rate for a 5-year variable mortgage is 2.44 per cent (expressed as prime minus 1.26 per cent).

Interest Rates Are On the Rise

Variable mortgages have been especially attractive over the last decade because rates have been falling. There was little chance of a rate hike, and especially not up to a point where a variable mortgage would be as expensive as a fixed one.

But now rates are going up. The Bank of Canada’s key interest rate has gone up from 0.50 per cent in mid-2017 to 1.50 per cent today. That’s four quarter-point hikes in a year and a half, and the Bank of Canada’s governor Stephen Poloz was recently quoted saying he would consider raising rates again even if he doesn’t have to.

It appears interest rates of all kinds are going to continue going up over the coming months and years, unless a significant recession comes along.

Should I Choose Fixed or Variable?

Even though variable mortgage rates are likely to rise over the coming years, they may still be a better bet if you’re buying a home or renewing your mortgage. There have only been a few times over the course of history when a new fixed-rate mortgage proved the better option, and while there’s a real risk of that happening now, it’s still unlikely.

Let’s assume two people get a new mortgage today for $500,000 with a 25-year repayment schedule.

According to Ratehub’s mortgage payment calculator, a fixed-rate mortgage with a rate of 3.14 per cent will cost you $2,402 per month, and $72,654 in interest over the first five years.

The same mortgage with a variable-rate of 2.44 per cent will cost $2,225 per month and $56,172 in interest over the first five years. If there’s no interest rate hike over the next five years, you will spend over $10,000 less on payments and save more than $16,000 on interest by choosing a variable-rate mortgage.

But What if Rates Do Go Up?

Unless rates rise dramatically, there’s a good chance that a variable-rate mortgage could still outperform a fixed-rate mortgage over the next five years.

Assuming an annual interest rate rise of 0.25 per cent, the variable-rate mortgage won’t have a higher rate than the fixed-rate mortgage until year four, and will top out at 3.44 per cent – only 0.30 per cent higher than the fixed rate.

Even though the interest rate at the end of 5 years will be higher than that of a fixed-rate mortgage, a mortgage with a variable rate that starts lower and ends higher will still cost less in interest over the term. The same $500,000 mortgage amortized over 25 years with a variable rate that starts at 2.44 pe cent and goes up by a quarter of a percentage point at the end of each year will cost $67,808 in interest over the first five years. That’s still almost $5,000 less than the $72,654 in interest the fixed rate would have cost.

^{A variable-rate mortgage that starts low and steadily increases will cost less in interest over a 5-year term than a fixed-rate mortgage, based on today’s best mortgage rates. This table assumes a $500,000 mortgage amortized over 25-years.}

Variable Isn’t Always Better

The math above assumes a gentle swing upward in the prime rate over the course of many years. That would return the prime rate to its highest since 2008, but still a few percentage points lower than where it was in 2007, before the Great Recession. If interest rates were to go up by 0.50 per cent per year rather than 0.25 per cent, the balance would tip in favour of the fixed mortgage fairly quickly.

It’s important to note that nobody knows what will happen with interest rates, and they could go up at any time. The prime rate once exceeded 20 per cent for a brief time in the 1980s. While that’s unlikely to happen again, it’s not impossible.

If you look at the history of mortgage rates in Canada, variable-rate mortgages have been the better option most of the time, but fixed-rate mortgages have been far more popular because of the security they provide.

It all comes down to your tolerance to risk. If you think it’s worth spending a few thousand dollars more in interest to potentially avoid spending tens of thousands more in interest, then a fixed-rate mortgage is best for you. Conversely, if you can’t stand the thought of paying more than you have to, a variable-rate mortgage will save you some money, if only temporarily.

The good news is you always have options. If you choose a fixed-rate mortgage, you know what you’ll pay no matter what. If you choose a variable-rate mortgage, you can always convert it to a fixed-rate later on if it proves too risky for your liking.

There’s no crystal ball. Nobody can see into the future to tell you which type of mortgage will turn out to be the best choice. History is wont to repeat itself, but it’s up to you to decide which slice of history you think is coming back next.