Fixed or variable? It’s a perennial question for mortgage seekers that’s expected to hit a fever pitch as the Bank of Canada begins what’s expected to be a steady stream of interest-rate increases in the coming months.
On Wednesday, the central bank increased its key interest rate to 0.50 per cent from a record low of 0.25 per cent. It’s the first rate hike since 2018. The increase will affect the cost of borrowing for various loans, including mortgages.
With a fixed-rate mortgage, the interest rate and payment stay the same over the mortgage term. With a variable-rate mortgage, the interest rate will move alongside the lender’s prime interest rate, which can take a week or more to adjust to central bank rate changes. In contrast, fixed mortgage rates are often set according to government bond yields. Both mortgage products, however, often carry rates below, or discounted from, advertised rates set by lenders.
About three-quarters of mortgages were fixed in 2020, according to a Mortgage Professionals of Canada study, suggesting many Canadians favour the payment certainty that comes with a locked-in rate.
Still, variable-rate mortgages remain in high demand, making up about 40 per cent of all new loans in the second quarter of last year, a Canada Mortgage and Housing Corp. report notes, driven by the large discount between fixed and variable rates.
Borrowers who go variable need to feel comfortable with fluctuating rates, says Ian Wood, a certified financial planner with Cardinal Capital Management Inc. in Winnipeg.
“I would be having a discussion with my clients about their decision, helping them understand their ability to manage rising interest costs based on their budget,” he says.
Many borrowers don’t understand the financial impact of an interest-rate increase and may even overestimate it, says Leah Zlatkin, a mortgage broker with Mortgage Outlet Inc. in Toronto.
“As a general rule, you pay about $12 a month more per $100,000 of mortgage for each 0.25-per-cent increase,” says Ms. Zlatkin, also an expert with Lowestrates.ca, adding this can vary based on amortization and other factors.
She notes the spread, or difference, in rates between a fixed and variable mortgage (based on five-year, closed terms that typically offer the best rates) is wide enough that the Bank of Canada would have to increase rates several times before most existing variable mortgages would have more costly monthly payments than most fixed-rate mortgages offered today.
For example, a typical five-year term mortgage on a home priced at $750,000 with a 15-per-cent down payment amortized over 25 years with a variable interest rate of 1.5-per-cent interest – discounted 1.2 per cent below prime – has a monthly payment of $2,620. In contrast, a typical five-year fixed mortgage at 2.6 per cent has a monthly payment of $2,970 (figures provided by Lowestrates.ca as of March 3).
Ms. Zlatkin says the central bank’s benchmark rate would have to increase by at least 100 basis points, or 1 per cent, to make the variable-rate mortgage more costly than the fixed-rate mortgage. And that is not accounting for savings of $350 a month until the Bank of Canada increases rates enough for variable-rate mortgages to become more costly than most fixed-rate mortgages being offered today.
Variable-rate mortgages are also more flexible, especially if you break your mortgage before its term is complete. Ms. Zlatkin estimates as many as six in 10 borrowers wind up breaking their mortgage before the term is up.
“They’re either moving, renovating or breaking their mortgage for a variety of reasons,” says Jeff Sparrow, a Winnipeg mortgage broker and managing partner at Castle Mortgage Group, who sees this happen regularly among his clients.
Breaking a variable mortgage can result in a penalty equal to three months of interest costs, while breaking a fixed mortgage could lead to a steeper penalty because lenders use what’s called an “interest rate differential” calculation. The penalty could be tens of thousands of dollars, depending on the size of the mortgage. By comparison, three months’ interest is likely to cost a few thousand dollars at worst, Mr. Sparrow notes.
Even borrowers who feel more at ease with a fixed-rate mortgage should consider variable-rate products, Ms. Zlatkin says.
“You can get a variable-rate mortgage, for example, where payments do not increase with interest-rate hikes, but the amortization stretches out instead.”
Another strategy for a variable-rate mortgage is to take the difference in monthly payments between the variable and a fixed-rate mortgage “and put that sum toward principal,” she says. “So even if rates go up six times, by the time that happens, you will have paid so much more principal that you are still likely to be far ahead.”
Of course, the biggest challenge for borrowers is that nobody can predict where interest rates will be a year from now, much less in five years, Mr. Wood says.
“Everyone has been talking about rates going up for the last 20 years,” he notes, and yet rates have been hovering around historic lows.
“But just because we’ve seen rates stay low for so long isn’t a reason to believe rates will stay low,” he adds.
Variable-rate mortgage holders generally can switch to a fixed-rate product without penalty from the same lender before the term ends, Mr. Sparrow notes. But borrowers should understand the interest rate offered on a fixed mortgage at that period is likely to be higher than current offerings today.
“In the end, choosing a variable or a fixed-rate mortgage really comes down to an individual’s preference and situation,” Mr. Sparrow adds. “So there really is no definitive right or wrong answer.”