Fixed or Variable Mortgage – what’s the difference?

First, let’s touch on the difference between fixed and variable rates…

With a fixed-rate mortgage, your interest rate and payments are fixed for the term of the mortgage, which offers stability.  Fixed-rates are usually better suited to people that have a low appetite for risk.  A fixed rate mortgage is locked in, so it’s harder to take advantage if rates trend downwards, and your rate will typically be higher than a variable mortgage at the time of application.

A variable-rate mortgage presents a bet on two fronts…

The first, and most obvious, is whether interest rates will go up or down.  Interest rate adjustments are based around the Bank of Canada’s changes to the overnight lending rate, which it uses to curb inflation and stimulate or cool the economy.   The Bank of Canada meets 8 times per year to adjust this rate, historically moving the rate in 0.25% increments, when they do.  A strengthening and growing economy, will typically result in the Bank of Canada increasing the interest rates.  An economy that is struggling or in recession would typically result in a decrease in this rate.  Mortgage lenders will increase or decrease their prime lending rate, the rate which you mortgage interest is based on, in unison with the adjustments made by the Bank of Canada.  Future changes are hard to predict with any certainty, however some certainty can be provided by historical trends and future projections.

The second, and in my opinion the more important of the two gambles, relates to the prepayment penalty.  On average, 6.5 in 10 Canadians will break their mortgage in 33 months.  Some of the reasons for this would be a sale of the property, to access equity for renovations, investment or debt consolidation, or removing one of the owners from title due to separation, divorce or loss of life.

The benefit of a variable rate mortgage lies in how this penalty is calculated.  A variable rate mortgage comes with a prepayment penalty of 3 months interest, typically about 0.75% of your outstanding mortgage balance.  The reason is because the lender can re-lend the money at a similar rate to what you are currently paying, and so they charge you 3 months interest to get out of your contract.  A Fixed rate mortgage prepayment penalty is calculated based on the greater of 3 months interest or what the lenders call an Interest Rate Differential calculation.  This is basically a calculation of the loss of income the lender will experience by allowing you to break your contract, and then having to re-lend the money out a current rates.  This calculation factors in the risk that the lender took originally by allowing you to lock  in a rate for an extended period of time.  Typically on a 5 Year Fixed, this calculation results in a penalty of about 4.5% of your current mortgage balance.  On a mortgage of $500,000 – that would result in a difference in the two penalties of $18,750 ($3,750 – 5 Year Variable vs  $22,500 – 5 Year Fixed).

This is why for me, the penalty is the bigger of the two gambles.  Are you willing to bet that you won’t be one of the 6.5 in 10 Canadians that breaks your mortgage early.  There are options to take a shorter term fixed rate mortgage, such as a 2 year fixed, where your penalty would be similar to a variable rate penalty, but depending on the state of the interest rate market, these options are sometimes not all that competitive.  Currently, the 2 year fixed mortgages do not have a competitive advantage that makes them worth considering.

At minimum, this topic requires a further conversation between us and consideration on your part about the plan for your home and your future.  There are many intricacies offered on Variable Rate mortgages that vary from lender to lender, that can help mitigate risks associated with fluctuating interest rates that we can discuss further.

I look forward to discussing this topic with you in further detail if you are interested.