Mortgage Basics

How to Choose Between Fixed vs. Variable Rate Mortgages

How to Choose Between Fixed vs. Variable Rate Mortgages
Written by
  • Alivia Massimillo
| 21 February 2023
Reviewed, 25 May 2023

Table of contents

    Choosing a fixed vs. variable mortgage rate is one of the first and most critical decisions any homebuyer must make when deciding on a mortgage. Understanding the options available to you and weighing their pros and cons ensures you’re selecting the best solution, which may not always be the lowest rate. So now you may be asking yourself, what exactly is the difference between fixed and variable mortgage rates? Which one is right for me? Read on to learn more.

    Key Takeaways

    • Fixed interest rates remain the same, while variable interest rates may fluctuate over the term.
    • Historically variable terms have provided more savings for borrowers.
    • Short-term fixed rates can help you ride out uncertainties in the market.

    What’s the Difference Between Fixed and Variable Rates?

    A fixed-rate mortgage has a fixed interest rate, which will remain the same throughout the mortgage term. 

    So how does a fixed-rate mortgage work? 

    With a fixed rate, your interest rate will only need to be renegotiated at the end of each term over your mortgage amortization period. 

    • The monthly interest and principal payment will remain the same for the mortgage term, regardless of whether rates increase or decrease. 
    • Rates for fixed mortgages are strongly linked to the bond market. When bond rates go up, fixed-rate mortgages generally do the same.

    A variable-rate mortgage has a fluctuating interest rate, while monthly payments generally remain the same. 

    So how does a variable rate mortgage work? 

    Your monthly payment’s interest and principal portion could fluctuate if rates increase or decrease.

    •  If rates increase – more of your payment will go toward the interest portion of your mortgage.
    •  If rates decrease – more of your payment will go toward the principal portion of your mortgage. 

    This is true for variable rates with fixed payments. 

    However, if the variable mortgage has adjustable payments, then the interest portion of your payment will adjust (increase or decrease) along with changes to the lender’s prime rate.

    How often do variable rates change? 

    Variable rates change with the lender’s prime rate (the benchmark interest rate that Canadian banks charge their customers plus or minus any discounts). The prime rate will vary with the performance of the Canadian economy and inflation forecasts. This means variable rates will change whenever the Bank of Canada (BoC) adjusts the target for the overnight rate. This occurs on eight fixed dates each year. 

    Pros & Cons of a Fixed Rate Mortgage

    The interest rate for a fixed-term mortgage remains the same throughout the term. You know exactly how much is going toward the principal and interest each month and can easily predict when the balance will be completely paid off. Fixed rates take the guesswork out of budgeting since you know exactly how much you’ll need to pay each month over your fixed term. 

    If interest rates decreased over your mortgage term, you wouldn’t be able to take advantage of the lower rates as you could be locked into a much higher rate until your term ends. Fixed-rate mortgages typically have much higher fees for breaking (say, if you decide to sell) during the term. These fees, known as mortgage discharge penalties, can be difficult to calculate or predict.  

    Pros & Cons of a Variable Rate Mortgage

    If interest rates decrease during your mortgage term, there could be significant cost savings. This means you’ll likely save more on interest over the long term. 

    Another benefit is that your mortgage can be locked into a fixed rate at any time (say, if interest rates start to increase), this is known as an early renewal. Variable-rate mortgages also typically have lower overall fees for breaking the mortgage (say, if you decide to sell) during the term. This fee is generally calculated as 3 months’ interest. 

    If interest rates rise, you could pay significantly more over fixed rates. If you choose to lock into a fixed rate at that time, the cost of the fixed rate could be much higher than if you initially locked into a fixed rate. 

    How much can variable rates change?

    As there is little predictability, variable rates may be difficult to budget. If rates increase substantially, there is the risk of hitting your trigger rate (the point at which your payments only cover interest and no longer cover any principal portion of the mortgage).

    Comparing Historical 5-Year Fixed and 5-Year Variable Rates

    When shopping for and comparing variable vs. fixed mortgage rates, it’s important to consider historical trends. Looking back over the 5-year fixed and 5-year variable rates can provide context, such as how economic conditions influence the rates available on the market today and where they may be heading in the future. 

    Historically, 5-year fixed-rate mortgages have been more expensive than their 5-year variable counterparts. However, this trend has recently seen a shift as variable rates become increasingly higher than fixed rates as market conditions shift. 

    Popularity Shifts Between Fixed and Variable Rates Over Time

    Variable interest rates have seen a surge in popularity, becoming the most popular choice among homebuyers due in part to the low rates offered in the first two years of the COVID pandemic. Another factor in this surge in popularity has been the mortgage stress test. With variable rates significantly lower than fixed rates, lenders have, up until now, allowed borrowers to qualify for a more significant amount. 

    Today this popularity is shifting once again as the spread between fixed and variable rates disappears. More borrowers opt for shorter-term fixed rates while they ride out current economic uncertainties. 

    Choosing Shorter-term Fixed & Variable Rates to Time BoC Rate Changes

    With so much economic uncertainty, choosing a shorter-term fixed or variable rate may make more sense to try and time the market and realize cost savings. Locking into a short-term fixed rate of 1-3 years provides immediate stability in mortgage payments to ride out any future prime rate increases that may happen while the BoC works to control inflation. 

    Meanwhile, locking into a short-term variable rate allows for immediately realized savings if interest rates should fall during the term while also remaining the most flexible option for breaking any time without significant penalties.

    Why Some Canadians are Switching from Fixed to Variable Rate Mortgages 

    Because the spread between fixed and variable rates has virtually disappeared, many Canadians may stick with or switch to variable rates for their flexibility and the low costs associated with breaking them. If you don’t plan to stay in your home for 5-years, a variable term may be more favourable as the prepayment penalty will be significantly less than if you were locked into a fixed rate term. 

    On the other hand, if you plan to stay in your home long-term and feel the need for financial stability – you can lock into a fixed rate at any time. 

    What Rate to Choose If Interest Rates Increase

    When choosing a rate, you must consider the current market conditions and your financial situation. Choosing a fixed rate may make sense if you anticipate that interest rates will continue to increase. There is greater peace of mind in knowing that you have predictable and stable payments during economic uncertainty. 

    Fixed rates will provide the most benefit for those buyers that cannot weather increased payments and where the risk to capital is too high in the face of ever-changing market conditions. 

    What Rate to Choose if Interest Rates Decrease

    Deciding whether fixed or variable is the way to go when interest rates decrease can be difficult. It’s essential to consider the term as well as your financial situation. Choosing a variable rate may make the most sense if you believe interest rates will continue to decrease. 

    If rates decline, those that have opted for a fixed rate will be locked into a higher rate for the duration of their term, while those that have opted for a variable rate will see immediate cost savings as more principal will be paid down. 

    Variable rates provide the most benefit for buyers with the financial stability to weather the changing market conditions. Also, variable rates allow the flexibility of locking into a fixed rate at any time should market conditions begin to change. 

    Frequently Asked Questions

    Can I switch from a fixed-rate mortgage to a variable-rate mortgage?

    It is only possible to switch from a fixed to variable rate mortgage by first breaking the fixed rate mortgage. This will come with significant interest rate differential penalties that may negate any cost savings you would obtain by moving to a variable rate.

    What causes mortgage rates to change?

    The Bank of Canada influences rates through the target overnight lending rate. The BoC may raise its target rate to slow inflation when the economy grows. Meanwhile, when the economy is weak, they may lower the rate to help stimulate the economy. The target overnight rate then influences mortgage lenders’ prime rates (the rate charged to borrowers). 

    Why are 5-year terms most popular in Canada?

    The most common term is the 5-year mortgage term making it the most popular in Canada, likely due to how widely advertised it is by lenders. 5-year terms generally offer lower interest rates when compared to 1, 3, 7, and 10-year terms. This means borrowers save money on interest over the term by opting for 5 years.  

    Wrapping it up

    When deciding between fixed vs. variable mortgages in Canada, weighing the pros and cons of each option is essential. Fixed-rate mortgages offer the security of knowing your payments will remain consistent over the life of your mortgage. In contrast, variable-rate mortgages can provide you with a lower interest rate and more flexibility. The decision between fixed and variable depends on your financial situation and goals.