Should I Choose a Fixed-Rate or Variable-Rate Mortgage?

The more popular mortgage amongst Canadian homeowners is the fixed-rate mortgage. As the name suggests, the interest rate remains the same over the term of the mortgage. A typical term is one, three, five or 10 years. While each lender sets its own prepayment terms and interest rates, there are similarities across the board.

There are two main types of fixed-rate mortgages:

• Fixed-rate closed mortgages
• Fixed-rate open mortgages

Fixed-rate closed mortgages offer the security of a static mortgage payment for the length of your term at a lower interest rate compared to an open mortgage. The tradeoff is fewer prepayment options and larger penalties if you need to break your contract.

In general, with a fixed-rate closed mortgage you can:

• Anticipate your monthly payment for the full length of the term, regardless of interest rate changes
• Prepay a percentage of your original mortgage amount, usually 10%, once per year
• Increase your payment at any time, typically up to 100% of your usual amount

Fixed-rate open mortgages give you the security of a fixed interest rate with the flexibility to pay off as much of your mortgage when you want. This may be preferable if you are expecting some future money, such as an inheritance, or if you plan on selling your home before the end of the term. Terms are usually shorter, between six months or one year, and interest rates are typically higher than closed mortgages.

In general, with a fixed-rate open mortgage you can:

• Take advantage of falling interest rates as you’re not locked in for the long term
• Make large lump-sum payments or pay your mortgage off entirely
• Increase your payment amount, applying the extra directly to the principal

Some lenders, such as the big banks, also offer convertible mortgages that give you a short-term closed mortgage (usually six months) with a fixed interest rate and the flexibility to convert to a longer-term closed mortgage in the future without any prepayment charges. Rates are typically higher than closed rates, but lower than open rates.

Pros of Fixed-Rate Mortgages

• Your monthly payments will stay the same throughout your term.
• You’re protected from rising interest rates for the duration of your term.

Cons of Fixed-Rate Mortgages

• If interest rates fall, you’re locked in at a higher rate.
• Historically, fixed-rate mortgage rates are higher than variable rates.

Related: Get 5 year fixed mortgage rate or 10 year fixed mortgage rate

While the payment with a fixed-rate mortgage remains the same for the length of your term, with a variable-rate mortgage the interest rate charged can rise or fall throughout your term, according to movements in the prime rate.

There are two types of variable-rate mortgages:

• Adjustable-rate mortgages
• Variable-rate mortgages

Adjustable-Rate Mortgages (ARM) have a floating payment that changes in sync with the prime rate. When the prime rate goes up due to a Bank of Canada interest rate hike, your payment will also go up, and move in the opposite direction if the BoC cuts rates.

In times of economic stability, borrowers may see little to no change with their monthly payments. But Canadians who took out ARMs during the pandemic will have experienced up to 10 interest rate hikes. The impact is felt almost immediately, as the new rate (and higher payment) will go into effect with your next payment. However, the amount that goes towards paying your principal remains the same, as does your amortization.

Variable-Rate Mortgages (VRM) have a fixed or static payment, similar to a fixed-rate mortgage, so the amount you pay each month stays the same. However, the amount you pay in interest changes is in sync with the prime rate. This means that during a period of rising interest rates, the amount of interest you pay on your loan also goes up, with less going towards your principal.

Each VRM has a trigger rate, or the point at which the fixed payment only covers the interest rate, and not any of the principal amount. At this point, borrowers may need to increase their mortgage payment to cover the larger interest payment. Some lenders allow for a negative amortization, where the interest payment exceeds the mortgage payment. In this case, borrowers will need to extend their amortization at renewal, or face significantly higher mortgage payments.

Pros of Variable-Rate Mortgages

• You can take advantage of falling interest rates almost immediately.
• If you need to break your mortgage, the penalty is usually less than the cost of breaking a fixed-rate mortgage.

Cons of Variable-Rate Mortgages

• You’re vulnerable to rising interest rates for the length of your term.
• With a VRM during rising interest rates, you may be adding to your principal, not paying it down.

To understand what’s happening with mortgage rates, it can be useful to decode some basic economic principles. We know that interest rates affect mortgage rates, but it’s a bit more nuanced than that. Fixed-rate mortgage rates are priced off of Government of Canada 5-year bond yields that are, in turn, influenced by the U.S. Treasuries. Variable-rate mortgages are affected by the Bank of Canada’s monetary policy, namely interest rate hikes and cuts that, in turn, impact the commercial banks’ prime lending rate.

To get a better grasp of how mortgage rates fluctuate and where they might be going, it’s helpful to unpack the differences between bond yields and monetary policy a bit more. Here’s an essential guide on how interest rates and mortgage rates work.

There are so many factors at play that affect the movement of interest rates. And financing a mortgage can be a very emotional decision, given the large sums at stake. While history can provide guidelines, there are no guarantees when it comes to timing or making the most cost-effective decision.

“There’s been 20 years of home ownership where no one has seen these kinds of rate increases, so why would anyone have them top of mind?” says Larock, referring to recency bias that rates will always be low. “Now the recency bias has gone the other way.”

Put differently, just because rates are currently high, it doesn’t mean they will always be high. Just as 20 years of low rates eventually came to an end: “Looking back in hindsight, it’s obvious after the first hike, anybody should have locked in at that point,” says Larock.

When thinking about whether to go with a fixed-rate mortgage or a variable-rate mortgage, there are different considerations, including your ability to withstand risk and volatility.

“Some people just aren’t suited for the uncertainty inherent in a variable rate,” says Larock. “The question I ask every borrower who’s deciding between fixed and variable rates is, are you more likely to lose sleep at night worrying that rates are going to go up or worrying that you’re paying too much interest? Because the answer to that question is going to get you about halfway to your answer.”

Larock does, however, offer some additional guidelines.

For an existing homeowner: If you have lots of equity in your home and fluctuations in your mortgage aren’t going to negatively affect your household budget, the fixed versus variable decision comes down to what you think rates will do in the future.

For a new homebuyer: If you’re a first-time home buyer and you’re taking on a good sized mortgage, a fixed-rate mortgage provides certainty and stability on what those payments will be.

Larock cautions against thinking about converting from a variable-rate mortgage to a fixed-rate mortgage to cut losses. The hazard, he explains, especially if you’ve been already paying the higher rates, is that effectively you risk locking in at these higher rates and eliminating the potential to participate in some savings in the future.

“People have been scared off variable rates at the very time when their appeal is increasing,” says Larock, especially when you compare them to the fixed-rate equivalent. “Today you can get a five-year variable rate and a five-year fixed rate for about the same. If you lock in a five-year fixed rate, then you’ll have no opportunity for potential savings down the road.”

It’s also important to remember to consider the term of your mortgage, typically one, three, five or 10 years. That’s because you can choose one type of mortgage in the short term, say a fixed-rate mortgage, to ride out the economic uncertainty, and then another product in the future upon renewal.

“The vast majority of clients that I work with are choosing a fixed-rate mortgage,” says Larock. “They’ve been scared off of variable. They don’t like the uncertainty. But they’re not choosing the five-year fixed-rate as they most commonly did. Now the three-year fixed-rate is the most popular rate that I see.” Borrowers, according to Larock, “think three years is enough time for inflation to come down and for things to moderate.”

Regardless of the math, “You can’t put a price on a good night’s sleep and peace of mind,” he says. “That factor alone is the reason why there is no ‘one size fits all’ answer for anybody.”