Fixed Rate vs. Variable Rate: What One Should I Choose?
75% of Canadians choose fixed-rate vs variable-rate mortgages
because they want the "peace of mind" of paying the same every month and the rate not changing on them...but do they have the full picture? And what is best for you?
Most home buyers are unaware of the advantages when choosing a variable rate and have some misconceptions based on its name. Based on the past decade and a half, variable rates have been slightly lower than fixed rates, aside from 2007 and 2019. This may sound like a no brainer for a lower rate, but before you start leaning to one side instead of the other, let’s take a step back and understand what a fixed and variable rate means and the pros and cons of each. To conclude I’ll provide case studies on how to leverage a fixed and/or variable rate so you can determine which one is right for you.
Definition of Rates & Pros and Cons
WHAT IS A VARIABLE RATE?
A variable rate is determined by the Bank of Canada’s lenders’ prime rate. The variable rate will fluctuate accordingly to the prime rate which can change as often as every few months or seldom as 2+ years.
Pros of Variable Mortgage Rates
Lower mortgage default penalty – Calculated by 3 months of interest
Switch to a fixed rate without incurring any fees
Low variable rates expected for at least 2 years, experts say
Cons of Variable Mortgage Rates
You cannot guarantee a low rate if rates go up like you can with fixed
Monthly payments and rates can fluctuate higher over time. However, there are a few select lenders that will keep your monthly payments fixed even if variable rates go up. Be cognizant that your term length will increase including amount of interest.
Note that it is very rare for a rate change to be more than .25%.
Rule of thumb: For every $100,000 of mortgage you borrow, a .25% rate fluctuation causes a $13 monthly increase or decrease. E.g on a $300,000 mortgage, a rise in .25% means you pay $39 extra a month.
WHAT IS A FIXED RATE?
A fixed rate means what it states, this rate is locked in during your mortgage term. The fixed rate is determined by the Government of Canada’s bond yields.
Pros of Fixed Mortgage Rates
Fixed monthly payments and interest rate – no surprises during term
Cons of Fixed Mortgage Rates
Possible higher mortgage default penalty – Use the higher of either 3 months interest or Interest Rate Differential (IRD). The IRD is calculated from the current rates and your mortgage balance. Average penalties (especially with banks) range from $15,000-$50,000 so be sure to do your homework prior to avoid being locked in or exposed to crippling fees.
Incur penalty to change rate during fixed term period
Most people don't realize that there is a 60% chance that you will be paying your bank anywhere from $15,000 to $50,000 penalty as that is the percentage of people who break their mortgages before their 5-year terms are over. There are many somewhat innocent mortgage strategies that change the structure of the mortgage and therefore are counted as breaking it so ensure you read below to anticipate what these situations could look like.
Reasons How a Mortgage Can Be Broken
Refinancing: Many people need cash for emergencies, debt consolidation, or investment opportunities and need to pull equity out of their home. Unless your mortgage has a Home Equity Line of Credit (HELOC), you will need to break the mortgage.
Lower Rates: People who got mortgages in 2018 had rates over 3% and suddenly saw rates over half of that in 2020 - would you want to keep paying double what your friends in 2020 are? Getting a lower rate with the same lender or elsewhere means breaking the mortgage.
Home Sale or Divorces: A divorce usually means needing to sell the home which, unless it’s portable, means you need to break the mortgage.
Moving cities for work: Some credit unions treat this as a trigger to break the mortgage.
Case Studies
FIXED RATE CASE STUDY
Paulina is about to retire and she has about $200,000 left on her mortgage for a home she does not plan on selling. She is no longer working and has a comfortable savings. She doesn’t plan to move cities and there is no risk of divorce as she has been separated from her husband for many years. This is a good case for a fixed rate as refinancing, a divorce, or moving is unlikely.
VARIABLE RATE CASE STUDY
Cory and Liana are recently newlyweds and have just gotten their first home. Both see it as an in-between home and want to upsize in 2-3 years once they have saved more down payment and have moved up in their work positions. Getting a raise at work might mean moving cities for a period of time but as opportunists, they are happy to follow the money as they are ready to build a family whom they want to support. They both have student debt remaining alongside credit card debt from the wedding and would like to pay that off at some point. This of course is a good case for considering a variable rate as their life is quite variable itself and having options is crucial for their goals.
THE BOTTOM LINE
As a home buyer, having a fixed mindset of locking in a fixed-rate mortgage may cost you more down the line so you need to understand the risks and not have blind faith in your local bank - remember that they make money from mortgage penalties. By educating yourself on both mortgage rates options and the pros and cons will help shape your understanding of what rate is best for you. A rate that you can not control may seem more costly at first however, many home buyers have leveraged variable rates into their strategy and have benefited because their life journey is not fixed.