As you navigate through various mortgage solutions, qualification numbers, and interest rates; you may inadvertently skip a very important discussion – Fixed Rate vs Variable Rate.
This question sounds so innocuous that most people pick one over the other without discerning the critical differences between the two rate types.
The type of rate you choose will have a bearing on the amount of penalty if you break your mortgage mid-way, possible fluctuation in your monthly mortgage payment, and much more. I insist that you carefully evaluate the difference between these two rate types and make an educated decision.
Fixed Rate vs Variable Rate
|Fixed Rate||Variable Rate|
|Introduction||As the name suggests, this rate remains fixed for the course of the mortgage term. It guards you against the potential rate increase but also doesn’t change if market rates were to go down.||This rate is fluctuating and is usually a factor of the market interest rate, a.k.a. Prime Rate (eg. Prime – 0.50%). This relationship with the Prime Rate will remain constant throughout the term, but your rate (and mortgage payment) will change if and when the Prime Rate changes.|
|Can this rate change mid-term?||No||Yes|
|Can mortgage payment change during the term?||No||Yes|
|What affects this rate?||Fixed rates are generally decided by the banks based on the government bond yields. They are not directly impacted by changes in Bank of Canada’s overnight rate and/or the Prime rate.||Variable rates (as mentioned earlier) are directly related to your bank’s Prime Rate, which in turn is partially based on Bank of Canada’s overnight rate.|
|Rate Comparison||In most cases (not all), Variable rates are lower than the fixed rates. The difference between the two rates can generally be based on the bank’s expectations of the Prime Rate’s direction.|
Prepayment privileges are more or less the
same for both rate types and are governed by the bank’s policy.
If you were to pay off the entire mortgage
before the end of the term, your prepayment penalty will most likely be calculated
using the Interest Rate Differential (IRD) method. The penalty, in such case, is generally
higher than variable rate.
If you were to pay off the entire mortgage
before the end of the term, your prepayment penalty will be most likely 3
months of interest. This amount is
generally lower than its fixed counterpart.
|When to choose?||
If you think that rates are going to go
upwards or if you are risk averse, Fixed Rates may be the best choice for
If you are positive about a potential
decline in the Prime Rate and/or are a risk taker, a variable rate may be a
good choice for you. It can pay you
rich dividends but can also make your monthly mortgage payments higher.
|Changing Rate Type||
Generally, you can only switch your Fixed
rate to Variable at the end of the term or if you break the mortgage.
Generally, lenders do allow you to switch
your Variable rate to the current fixed rate.
Are Variable Rates Really Risky?
To determine the risk attached with variable rates, I looked at Prime Rates for the last 10 years (2010 to 2020). The Prime Rate is currently at 2.45% (as of 24th June 2020). This rate was at 2.25% on January 1st 2010, moved up gradually to 3.00% by October 2010 and stayed there until February 2015. The rate then dipped a little first to 2.85% and then to 2.70% for June 2015 to June 2017 period. Following strong employment and inflation numbers, the Prime Rate went up gradually to 3.95% by October 2018 before declining to 2.45% in 2020 because of the pandemic.*
Therefore, it seems that the fluctuation in the rates is infrequent. As about the possible rate increase, if your variable rate is 0.50% to 0.75% cheaper than the fixed-rate, there may be sufficient buffer to address some rate increase.
In short; the type of rate you choose depends on your financial situation, the country’s economy, inflation rate, and rate trends among various others. Fixed-rate is not always the best option nor is variable rate the riskiest. You should choose based on what suits your needs the best. If you have any questions, call me at 647-709-2117.
Disclaimer: This information is put together for education purposes only. Before choosing the rate type, consult your mortgage professional and evaluate all relevant factors.