Fixed VS Variable
This is the ultimate question 99% of homebuyers struggle with. And if you are the average buyer, you’ll settle for the plain vanilla 5-year fixed (2 out of 3 Canadians end-up with it).
But why 5-year fixed? Is it because it’s what your parents always had, because that’s what everyone is advertising, because you don’t want to think about it for the next 5 years, or simply because variable sounds too risky…
Let’s be honest, these are not the most rational reasons. You are committing to the most important purchase of your life, and we believe it should be an informed one. Here is our best crack at the pros and cons of fixed vs variable, what misconceptions you should be aware of, and how to assess which one is right for you.
What is a Variable Mortgage Rate?
With a variable mortgage rate, the % rate can vary over the term of your mortgage (a term usually lasts 3-5 years). The % rate will follow the banks’ prime rate.
What is a Fixed Mortgage Rate?
With a fixed mortgage rate, the % rate you pay will stay the same. Usually, a fixed-rate mortgage tends to be higher than the variable rate. However, in recent years, the fixed rate has predominantly been the lower of the rates.
How does it work?
Variable Rate
8 times a year, the Bank of Canada meets to determine whether or not to adjust the overnight rate. Following the announcement, banks will adjust their prime rate. Your % rate will automatically reflect this adjustment (if any).
Fixed Rate
You guessed it, the rate you got initially doesn’t change.
Mortgage lenders’ fixed interest rates are closely tied to bond rates. Low yields on government bonds mean low rates on fixed rate mortgages and vice versa. When bond yields decline, fixed mortgage rates also come down – a direct relationship.
Since bond prices and interest rates move in opposite directions, as bond prices go down, fixed mortgage rates go up and vice versa – an inverse relationship.
Banks typically use 5-year bond yields to determine their fixed mortgage rates, taking the forecast earnings from bond investments to cover the costs and potential losses they might incur in the mortgage market.
As the 5-year bond yield rises, lenders’ margins will shrink and then ultimately disappear, as funding costs increase. When they can no longer absorb the increase it gets passed on to borrowers by way of higher fixed mortgage rates.
Banks don’t automatically raise fixed mortgage rates as bond yields increase, but when bond yields climb, fixed rates typically follow.
Main advantage
Variable Rate
You will likely save from the get-go!
If the spread between fixed and variable remains the same, our couple will save $7,500 in the first 5 years. ($37,400 over the lifetime of the mortgage assuming the spread remains for 25 years). This represents a lot of money on a $400,000 purchase.
The other main advantage is the luxury of choice! Penalties for breaking a variable mortgage are much more reasonable than for a fixed mortgage. We will cover this point in detail below.
Fixed Rate
The ultimate peace of mind!
Don’t worry about anything, forget about all the economics, sleep sound knowing your rate will never change (up or down).
Note that peace of mind comes at a cost… If the spread remains, you will have paid more interest than you would have with a variable mortgage.
Most common misconceptions
Variable Rate
“I can lock in at any time!?”
Ok, this isn’t a misconception but sometimes it is misunderstood. Yes you can lock in at any time BUT the rate you lock in at isn’t the variable rate you currently have nor is it the fixed rate you were offered when you applied for a mortgage. The locked in rate will be based off the current rates. If you are variable and want to lock in, its best to contact your mortgage broker to shop around. It may very well be worth it to break the current mortgage contract, pay out the pre payment penalty which is usually 3 months simple interest, and fix with another lender.
Fixed Rate
“I’m risk-averse, I want to protect myself: I prefer a fixed mortgage”
This will sound counter-intuitive, but know that you are taking on a very risky bet by choosing fixed: you will never break your mortgage – meaning sell your property, or refinance the mortgage within your term.
First, you need to know that most banks’ penalties on a fixed mortgage are astronomical. Second, it’s more likely than you think that people break their mortgage before the end of its term. You may move to another property, move in with your significant other, get a job in a different city, break-up with your partner (god-forbid), etc. The reality is that when it comes to mortgages, the average completed term is about 36 months (yep, that’s much less than 5 years).
What happens when you break your mortgage? With a fixed mortgage, you pay a significant penalty.
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Mortgage penalties
Variable Rate
Penalties are calculated based on 3 months’ interest. To calculate this, take your interest rate x mortgage balance / 12 months = 1 month penalty x 3 = 3 month penalty.
This penalty is roughly around $2500.
Fixed Rate
On a fixed mortgage, you will pay a maximum of 3 months of interest or the ‘interest rate differential’ – meaning paying back the interest owed until the maturity of the term (often based on much higher posted rates)
I have seen penalties to be up and around the $10,000 to $20,000 amount.
Yep, that’s a lot! Note that any cash back or fees paid by the bank at time of closing will need to be reimbursed as well.
When are you losing?
Variable Rate
When the Bank of Canada raises the overnight rate so much that your variable rate costs more in interest than the 5-year fixed rate.
Keep in mind that you will have saved for the entire time your variable rate was under the fixed. Only if the variable rate above the break even point, are you losing in this context.
Fixed Rate
When you break your mortgage early (before the end of the term).
You may move to another property, sell, move in with your significant other, get a job in a different city, break-up with your partner (god-forbid), etc.
When Bank of Canada does not raise the overnight rate at a fast pace – and a variable rate would have made you save more than picking a fixed rate.
Who is it for?
Variable Rate
You care about saving money upfront. You want flexibility, and value the low cost option of breaking your mortgage early.
You can live with some uncertainty about the future, and won’t lose sleep over it.
Fixed Rate
You really don’t want to think about your mortgage for the next 5 years, and you’ll sleep much better knowing your rate is fixed. You are absolutely certain you will not break your mortgage during the term.
A sudden change in your mortgage payment could significantly affect your budget.
Our preferred strategy for a variable mortgage rate
Even if your variable rate is less than a fixed rate, set your mortgage payment at the same amount using a prepayment privilege.
Why? You will pay more of your principal balance from the beginning (meaning you will own more of your property faster). This will help you save a lot over time! The more you own today, the less interest you pay to the bank over the next 25 years.
If your budget permits, go for bi-weekly accelerated payments. You will pay slightly more every month, but no interest on the increase and it will end-up paying your mortgage almost 3 years faster, and save big in interest!
Our preferred strategy for a fixed mortgage rate
Really take the time to assess your own personal situation, and determine how likely you are to sell, or switch to a new property within the term of your mortgage. If this is a real possibility, then seriously consider a variable rate mortgage.
If your budget permits, also go for bi-weekly accelerated payments. You will pay slightly more every month, but no interest on the increase and it will end-up paying your mortgage almost 3 years faster, and save big in interest!