March 22, 2017

Fixed-Rate vs Variable-Rate Mortgages: Which Is Right For You?

Canadian interest rates are hovering near historic lows, making borrowing money more attractive than ever. But prospective homebuyers looking to take on mortgage debt face a difficult choice. Should they choose a variable-rate mortgage in the hopes that rates will fall even lower, or lock in at today’s rock-bottom levels before interest rates begin to climb?

Know the Difference Between Fixed and Variable Mortgage Rates

With a fixed-rate mortgage, the interest rate remains the same for the entire duration of the loan. For example, in the case of a five-year fixed rate mortgage being offered at 2.44%, the borrower will continue to pay 2.44% for the full five-year term, at which point he or she will have to renew. This gives borrowers the peace of mind that their mortgage payments will not fluctuate, even if interest rates change. However, borrowers will have to renegotiate when it comes time to renew, as the same rate may no longer be available, particularly if interest rates have risen.

A variable-rate mortgage is one where the interest rate fluctuates along with the prime lending rate, which is the rate used by banks to set interest rates for various products. A variable-rate mortgage is usually expressed as the prime rate plus or minus a certain percentage amount—for example, prime minus 0.5%. That means that if the prime rate is 2.7%, the interest rate on the mortgage would be 2.2% (2.7% – 0.5% = 2.2%).

Related Read: Will the US Fed Rate Hike Mean Higher Canadian Mortgage Rates?

Variable-rate mortgages tend to be cheaper than fixed-rate mortgages, but they’re also riskier. That’s because as the banks change their prime rates—which typically happens in lockstep with the Bank of Canada’s overnight lending rates—the interest rate on your variable-rate mortgage will also change. If the rate increases, more of your payment will go towards the interest and less towards paying down the principal. And in some cases, your payment will also rise. If interest rates fall, the more of your payment will pay down the principal or your mortgage payment will decrease.

Which Rate Type is Better for Your Borrowing Needs?

To get an idea of what your mortgage payments will be with either a fixed-rate or variable-rate mortgage, you should use a mortgage payment calculator.

Fixed-rate mortgages are more popular, especially among first-time homebuyers, according to a report issued last December by Mortgage Professionals Canada. Its Annual State of the Residential Mortgage Market in Canada report found that 68% of mortgage holders have fixed-rate mortgages, while 26% have variable-rate mortgages. The remaining 6% have combination mortgages, where part of the payment is based on a fixed interest rate and part is based on a variable rate. Of the mortgages for homes purchased in 2016, 84% of first-time buyers opted for a fixed rate, compared to 66% of repeat buyers.

The popularity of fixed-rate mortgages can be partly explained by the fact that the spread between fixed-rate and variable-rate mortgages is currently quite low. Last year, it was about a quarter of a percentage point for five-year mortgages, according to the report. That means for borrowers who opt for variable-rate products stand to save only a little bit of money for the additional risk they take on.

Comparing Fixed and Variable Mortgages

Here are a few things to consider when shopping around for the best mortgage rates and trying to decide which type of mortgage is right for you.

	Fixed-rate mortgages	Variable-rate mortgages
Pros	Offer borrowers security in knowing that their payments will not change until the term is over. That eases anxiety and makes budgeting and financial planning easier.	They tend to save borrowers money over time, according to historical data.
Cons	The security of not having to worry about where interest rates go comes with a price because they tend to be more expensive.	The mortgage rate can rise and fall in tandem with the prime lending rate. A significant rise in rates could increase the interest you’d need to pay and your mortgage payment could also increase.

What Drives Mortgage Rates?

While variable-rate mortgages follow the prime rate, fixed-rate mortgages generally move in step with Government of Canada bond yields, plus a spread. Both prime lending rates and government bond yields are influenced by economic factors such as employment, manufacturing, exports, and inflation.

When inflation is high, the Bank of Canada will increase its overnight lending rate— which in turn will affect the bank’s prime lending rates—to cool down the economy and discourage spending. When inflation is low, the central bank will reduce interest rates in order to encourage borrowing and stimulate economic growth.

Keep this in mind when trying to determine which type of mortgage is right for you. If interest rates are expected to rise, it may be wise to lock at a low rate for a five-year term. If, however, there’s an expectation that rates may decrease, it may be worth the gamble of choosing a variable-rate mortgage that will allow you to benefit from any potential declines in interest rates.

RateHub.ca is a website that compares mortgage rates, credit cards, high-interest savings accounts, chequing accounts, and insurance with the goal to empower Canadians to search smarter and save money.