Buying a house is one of the biggest investments you’ll probably ever make, and that means your mortgage is likely the largest financial commitment you’ll ever take on. There’s a huge selection of mortgage products out there for you to choose from, and one of the main things you’ll have to decide is if you want a fixed-rate or variable-rate mortgage, and at the same time, a closed or open mortgage.
If you have questions about these two types of mortgages, we’ll tell you everything you need to know to choose the right one for you. We’ll talk about what fixed and variable means in terms of mortgages, who they’re suitable for, when is a good time to choose one over the other, and more.
What’s a fixed rate mortgage?
A fixed rate mortgage means the interest rate remains locked-in for the duration of the mortgage term. As an example, let’s say you negotiated a mortgage with an interest rate of 2.25% and a 5-year term. With a fixed mortgage, you’ll have that same 2.25% interest rate for the entire 5-year term.
This means your mortgage payment will be exactly the same every month (or every week or two weeks, depending on your payment frequency).
The main benefit of a fixed mortgage is stability because you always know exactly how much you’re going to owe, and that number won’t change until you renegotiate or renew (see our guide on the Mortgage Renewal Process).
The trade-off is that these mortgages tend to have slightly higher interest rates than variable mortgages.
How is the rate on a fixed mortgage determined?
The primary factor that determines the interest rate on a fixed mortgage are Government of Canada bond yields.
When a Canadian buys a bond, the government guarantees repayment plus interest, and that interest is called the yield. When the yield increases, so too do fixed mortgage rates. This is because when lenders have to pay out more interest to bond holders, they recoup that cost by increasing the interest they charge borrowers. Conversely, when the bond yield drops, so too do fixed mortgage rates.
Historical 5-year fixed rate vs. 5-year bond yield
However, bond yields and mortgage rates aren’t exactly the same, because there’s a spread to account for as well, which you can think of as a bank’s markup on the yield. In other words, if bond yields are at 0.6%, then fixed mortgage rates will be at 0.6% plus the spread. While it can deviate for short periods, the spread (difference) between 5-year yields and 5-year fixed rates always returns to its long-term average.
Bond yields are influenced by economic factors including inflation, exports and unemployment.
What’s a variable rate mortgage?
A variable rate mortgage has an interest rate that fluctuates with the prime rate. There are two ways you can set up a variable mortgage:
The first is that when the interest rate fluctuates, the amount of your mortgage payment changes. When interest rates increase, your monthly payment increases, and when interest rates go down, so too does your payment.
The second way for a variable mortgage to work is that your payment stays the same, but when interest rates fluctuate, the portion of your payment that goes toward interest changes too. For instance, when interest rates go down, your payment stays the same, more of that money is applied to the principal and less to interest. When interest rates increase, the total payment is the same, but more of your payment goes toward interest and less to principal which could increase your amortization period.
How is the rate on a variable mortgage determined?
The interest rate on a variable mortgage is set at the prime lending rate, plus/minus a percentage premium/discount. The prime rate is the interest rate commercial banks offer to their most credit-worthy customers, and it fluctuates based on the Bank of Canada’s policy interest rate, which the Bank uses to help keep inflation low and predictable and is based on the same underlying economic factors as the fixed rate (inflation, trade, manufacturing, unemployment, etc.)
The policy interest rate is also called the target for the overnight rate, where the overnight rate is the interest rate major financial institutions must use when they lend or borrow single-day loans to or from other financial institutions. When the overnight rate goes up, the prime lending rate will soon follow.
Historical prime mortgage rate vs overnight rate
When it comes to your home loan, if prime were at 2% and you qualified for prime + 0.35%, then your variable mortgage rate would be 2.35% to start. Although the interest rate on your mortgage would fluctuate over the term, its relation to prime would stay at +0.35% for the duration.
Whether your bank offers a premium (prime plus a percentage) or a discount (prime minus a percentage) at any given time depends on factors like mortgage market competition, economic trends and market conditions, and the share of the market they’re going after.
Should I get a fixed or variable mortgage?
The answer to this question will be different for everybody. There are lots of factors – both financial and personal – that you should consider before making a decision between the two mortgage types. Let’s look at a few of those now:
Many young and first-time buyers opt for fixed mortgages that let them budget more precisely. Buyers at this stage don’t always have a lot of savings and might still have other debts. The security of a fixed rate makes it easier for them to pay their mortgage while also putting money toward living expenses and things like car and student loans.
On the contrary, older and more established investors tend to opt for variable mortgages. They might have more savings to rely on, have fewer debts to pay off, and have more disposable income to play with if the rates increase.
Fixed mortgages are more stable and predictable than variable mortgages, so one thing you’ll have to consider is how tolerant you are — financially and otherwise — to risk.
Could you still cover your mortgage payments if there was a 2% increase in the interest rate? On a personal level, could you handle the potential stress of knowing that your interest rate will fluctuate? If the answer to either of these questions is no, then you might be better suited to a fixed mortgage than a variable one.
On the other hand, if you could handle the fluctuating interest rate and a less predictable mortgage payment, then a variable rate might be suitable for you.
Budget and income
If you’re on a tight budget and only have so much room in it for mortgage payments, then you probably couldn’t handle an increase, making a fixed mortgage a more suitable choice. However, if you have a larger budget and there’s still room to accommodate a higher payment, then you might be fine with a variable mortgage.
Another scenario that could impact what kind of mortgage you need is if your income fluctuates or is seasonal, because it could be more beneficial to have a steady mortgage payment you can budget for if you don’t always know how much money you’ll have coming in.
What mortgage will end up costing less in the end?
Although fixed mortgages have proved to be more popular over the years, studies have found that based on data from 1950 to 2007, the average Canadian could expect to save interest 90.1% of the time by choosing a variable-rate mortgage instead of a fixed. The average savings was $20,630 over 15 years per $100,000 borrowed.
That being said, it’s no guarantee that variable mortgages will always save you money. Nonetheless, there are certain times when economic factors make one type of mortgage preferable to the other, and we’ll talk about that now.
When is a variable rate better than a fixed rate?
In general, the gap between the current fixed and variable rate is a good measure of how attractive one is verus the other. As the gap between them increases (eg. fixed rate is more than 0.5% above the variable rate), variable rates become more attractive. This is because it would take 2 Bank of Canada interest rate increases by 0.25% each time in order to close the gap between the two and a third to make the variable rate more expensive.
When interest rates are low, as they are right now, it often makes sense to take advantage of those low rates and lock in with a fixed mortgage. This is especially true if those rates aren’t expected to continue falling, or it’s predicted that they’ll go up.
By contrast, if interest rates are a little higher than normal, or rates are forecasted to drop, then a variable mortgage likely makes more sense as you’ll save money if interest rates do indeed fall since your mortgage rate will fall with it.
Can I change my mind after I commit?
If you’re having trouble deciding between a fixed and variable mortgage and are worried about making the wrong choice, just remember that most lenders will let you convert a variable mortgage to a fixed one before your term is up.
There will be a penalty and you’ll have to pay a fee for this privilege, but chances are you won’t be stuck with a variable mortgage if you find it’s not the right fit. Just make sure you run the numbers before making this decision, because the cost of breaking a mortgage isn’t always worth it.
What other things should I consider when choosing a mortgage product?
Fixed or variable aren’t the only decisions you’ll have to make when it comes to your mortgage, and there are some features you might want to look for that could make your mortgage and payments more flexible, such as:
- Prepayment privileges that allow for payment increases, or lump sum payments that go directly to your principal
- Underpayment options in case you need some financial assistance and can’t make your full payment
- Portability that could let you take your mortgage with you if you move before the term is up
- Reborrowing capabilities such as a readvanceable mortgage that give you access to some of the money you’ve already put into the house
- Payment holidays that allow you to defer payments under some circumstances
What other factors might impact my interest rate?
No matter whether you opt for a fixed or variable mortgage, the interest rate you qualify for will depend on many different factors. One of the big ones is the lender you choose, but any lender will consider many factors when approving your loan and determining what rate you qualify for, including:
- Your credit score
- The length of your credit history
- The size of your down payment
- The cost of the house
- Location of the home (eg. rural versus urban)
- Your chosen loan term
- Amortization period
Choosing between a fixed and variable mortgage is an important step in the home-buying process, and the right choice will be different for every homeowner. There are lots of things to consider when deciding between these two mortgage products, including your income, risk-tolerance, financial goals, and age.
Variable mortgages do tend to be cheaper over the life of a mortgage, but fixed mortgages provide stability and predictability that can be more important than money. Just remember when choosing a mortgage that you should always shop around until you find a lender or broker that will work with you to get you the best rates and the best mortgage products, and help you with the important decisions you need to make to achieve your financial goals.
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Did you opt for a fixed or variable mortgage when you bought your house? Let us know about your past mortgage experience in the comments below!