Over the past six months, one of the most frequent questions that I’ve faced from Canadians is whether fixed or variable mortgage rates are best. As with any mortgage, there is no single answer to this question. In this article, I break down the factors that you want to consider when choosing an interest rate.

Fixed Rate vs Variable Rate

First, let’s jump into a quick refresher on the difference between fixed and variable interest rates. As you may know, a mortgage is made up of several terms. Each term ranges from 6 months to 10 years. For the duration of each term, both the borrower and lender are bound by the rate and terms set forth in that contractual agreement. One of the main focuses of this term is the interest rate that applies to the monthly payments.

Fixed interest rates stay the same and do not change throughout the mortgage term. The benefit of this type of term is that you have a fixed monthly payment. This fact helps you manage your budget from month to month since your housing payment will not change.

Variable interest rates are tied to a lender’s Prime interest rate and are typically based upon a discount from Prime. 

For example, if Prime is 2.45% and you receive a 0.85% discount, your net interest rate is 1.60%. This Prime rate is in turn governed by decisions made by the Bank of Canada and the Overnight Lending rate. As the Bank of Canada increases and decreases the Overnight rate, your mortgage rate moves respectively. So with a 1.60% interest rate on a $600,000 mortgage, a 0.25% increase by the Bank of Canada will result in an interest rate of 1.85% the payment increases $71 per month.

Conversion Privileges of Variable Rates

For Canadians that are in a variable rate mortgage, the majority of these loans are convertible into a fixed rate mortgage at any time. This allows you to lock into a fixed payment if you are concerned about interest rates moving up and increasing your payment. The one factor to keep in mind with conversion privileges is that they convert into: a fixed rate mortgage of equal length to their remaining term or longer, at the current available rate for that term and product. This fact means that if you are in a 1.60% mortgage, you won’t be locking into a 1.60% fixed rate. Instead you receive the rate available on the closest remaining available term – or a term that is longer.

Fixed Rate vs Variable Rate Prepayment Penalties 

One of the largest benefits of a variable rate mortgage is that they carry the smallest prepayment penalty. Remember, a prepayment penalty is incurred any time a mortgage is refinanced or transferred to another lender. You are also charged a penalty if you sell the property without moving – “porting” – the mortgage with the current lender to a new property. A variable rate prepayment penalty is typically 3 months of interest. This cost is roughly equivalent to 0.50% of the mortgage balance.

Fixed rate mortgages carry a risk of a higher prepayment penalty. The calculation for these mortgages is an interest rate differential (IRD). An IRD penalty is the difference between the interest rate on their contract and the currently available rate on a mortgage of similar length to the remaining term. 

This penalty calculation can increase the penalty many times, especially if your mortgage is with a bank. IRD penalties with a mortgage finance company are approximately equivalent to 2-2.50% of the remaining mortgage balance. Mortgages at the banks can be as high as 4-4.50% of the remaining mortgage balance.

Fixed rate vs variable rate: person stressed out at desk with head in their hands looking at their open laptop

Factors to Consider Regarding Fixed Rates vs Variable Rates

There are three main factors that we consider when helping clients choose a mortgage rate. These factors, listed below are our client’s financial goals, property goals and risk tolerance.

Financial Goals

What is more important? Paying your mortgage off faster or having the lowest monthly payment? Asking this question helps us determine the mortgage strategy we’ll want to use for your mortgage.

For Canadians looking to pay off their mortgage faster, maximizing interest savings is a key factor. Most variable rate mortgages are priced at a lower rate vs comparable 5-year fixed rate mortgages.

This discount means that each month the variable rate remains lower than the fixed rate, the more likely you are to save money versus a fixed rate. More importantly, you’ll also pay less money towards interest and more towards principal. Also, since the payment is lower, you have more cash-flow to use as a prepayment towards your principal balance. This strategy reduces the size of your mortgage faster and getting you out of debt quicker.

Keep in mind variable rates can rise and borrowers can see a higher rate of interest in future which claws back your savings. However, historically, variable interest rate mortgages have saved Canadians money versus 5-year fixed rates more than 80% of the time. The increased risk level of a payment that can fluctuate is traded off for a higher savings rate which helps you build wealth faster.

Fixed rate vs variable rate: Person in blue suit holding toy house

Property Goals

Another main factor in the interest rate decision is the goals of each individual client. We typically see three main types of clients when it comes to deciding between fixed and variable rates. First time buyers, change up buyers (upgrading or downgrading) and real estate investors. For each type of client, the goals they have for the property will be a driving factor in their decision.

First time home buyers are often buying a smaller home in an earlier stage of life. This first home is quite often one they’ll use to build equity before selling in the future to buy a larger home more suitable to their needs. As first time home buyers may not live in the home for an extended period of time, reducing prepayment penalties becomes an important objective. Additionally, they are at an early stage of life and less financially stable as compared to later stages in life. With these two factors taken into account, fixed rate mortgages with shorter term lengths often suit clients buying their first home.

Change-up buyers moving into their “dream home” are usually buying a home to spend the rest of their lives in. Since there is a higher chance of stability for these clients, we’re more comfortable discussing fixed rate mortgages with longer terms. However, as these types of clients are quite often more financially stable, variable rate mortgages are quite often more suitable when saving money is the primary goal.

Investors tend to be more tolerant of risk than most home buyers. They typically want the savings potential that comes with a variable rate and are comfortable with month-to-month fluctuations. Additionally, investors quite often restructure their portfolio several times throughout the life of their loans. Since they may need this added flexibility, the majority of our clients investing in real estate have variable rate mortgages.

Risk Tolerance

Everyone has a risk tolerance that is unique to their financial situation and life experience. There is one final question I ask all of my clients when determining their optimal mortgage strategy. “If your mortgage payment can go up and down, will you be able to sleep at night or will you be worrying about your mortgage payments?”. I have found that this question a simple way to understand our client’s mindset. This questions ensures that our clients’ will remain comfortable with the decision they make. 

Summary

As you can see, there are a lot of factors that go into determining which interest rate is correct for you. Thinking about long-term financial goals, property goals and risk tolerance are the main points to consider during this process. Think about these factors the next time you are buying a home or renewing your mortgage. Once you understand your long-term goals, it will be easier to determine whether a fixed or variable rate is best for your mortgage.

About the Author

The column's goal is to level up your financial knowledge and help you avoid common pitfalls and mistakes along the way. Although money management sometimes seems like an intricate task, it doesn't have to be. The advice here is common sense and simple to follow. The first step to a better financial future starts here, and it's never too late to begin. Adam Stapley is a Mortgage Broker with Pineapple Financial and author of the personal finance blog CanadianFinanceGuide.ca. He is intensely passionate about helping Canadians build wealth through the power of real estate. Many of the articles in this column come from Adam's experience assisting Canadians to understand and shape their personal finances. Pineapple Financial Lic #12830 CanadianFinanceGuide.ca adam@canadianfinanceguide.ca