Understanding Fixed vs Variable Rate Mortgages

In 2022, financial experts have been homing in on mortgage rates. Market analysts believe the Bank of Canada (BoC) will raise interest rates. The debate among housing observers, economists and investors is by how much. And with all this talk of fixed vs variable rate mortgages, what is the difference between the two products anyway? Let’s explore.

With Canada’s inflation rate the highest it has been since 1991, some anticipate the central bank will be aggressive on rate hikes, while others believe it will adopt a more cautious approach after about two years of ultra-loose and accommodative monetary policy in response to the pandemic.

One corner of the mortgage market attracting plenty of attention is variable rates.

Robert Kavcic, an economist at BMO, suggests that Canadian variable mortgage rates will likely witness significant increases this year. Variable rates could see a 100-basis-point hike, while five-year fixed-rate mortgages could experience a 50-basis-point increase.

“On the variable side, 100 basis points or more of BoC tightening is in the cards over the course of this year. For housing, the shift into lower-rate variable mortgages in 2021 kept the fire going, but the market will no longer be able to hide from higher rates this year,” Kavcic wrote in a note to capital clients. “Incomes will grow too but, all else equal, it will be hard for prices to keep powering through that given where valuations already are.”

Fixed vs Variable Rate Mortgages: Understanding the Differences

With a fixed-rate mortgage, borrowers’ interest rate and payment remain the same over the course of the mortgage term.

With a variable-rate mortgage, homeowners’ interest rate will rise or fall based on the lender’s prime interest rate.

Both types of mortgages have their pros and cons.

For a fixed-rate mortgage, borrowers have the confidence of knowing when they will pay off their mortgage. This allows someone to budget accurately every month, because they know what their payment will be for the prescribed term.

At the same time, a fixed mortgage interest rate is typically higher than the variable alternative, at first. Plus, should the borrower decide to end the mortgage prematurely, they will incur greater penalties than a variable rate.

So, what about the advantages and disadvantages of variable mortgage rates?

The interest rate on a variable-rate mortgage is typically lower than with a fixed rate. Should the prime rate move, so too will the mortgage interest rate. If the prime rate increases, a greater portion of the payment will be allocated to interest. If the rate falls, more will go toward principal, extending the amortization period.

Those who have a variable-rate mortgage and are concerned about an imminent interest rate hike can transition to a fixed-rate mortgage at any time.

With the central bank expected to pull the trigger on a few interest rate hikes this year, change could be on the horizon for variable rates, too.

“The impact on variable rates is direct in the sense that if the Bank of Canada moves up by 1.25 per cent, we should expect the prime lending rate to go up by that exact same amount. So the most obvious impact is on those who currently have a variable rate,” said James Laird, co-founder of rate comparison website Ratehub.ca, in an interview with the Business News Network (BNN). “They should expect their rate, and therefore their payment, to rise as the Bank of Canada rolls out interest rate increases.”

But, wait a minute. What is a prime rate anyway?

The prime interest rate is what financial institutions charge their customers. This varies based on the performance of the Canadian economy and inflation projections.

Meanwhile, there are variations of a fixed- and variable-rate mortgage:

• Open Fixed: Borrowers can prepay in full or partly to change to another mortgage term without fees and charges.
• Closed Fixed: Homebuyers will see their interest rate and payments remain the same throughout the term.
• Open Variable: Clients can make as many prepayments they want and either pay off the total balance or switch to a different term without penalties.
• Closed Variable: Homeowners will make the same monthly payments throughout the mortgage term.
• Adjustable Rate: Interest rate and payments will automatically adjust each month when rates increase or decrease.
• Lock and Roll: Your mortgage rate and payment will automatically change every six months.

What’s Right for You?

Should you choose a fixed or variable mortgage rate?

Historically, since real estate is generally considered a conventional safe-haven asset in any type of economy, many choose the fixed option because it allows for a steady approach to managing finances. That being said, in today’s sizzling Canadian real estate market, many homebuyers have opted for the variable rate and have enjoyed savings. But with interest rates only expected to return to pre-pandemic levels, some are wondering if this could be a time to lock it in. Work with a professional financial advisor the determine what’s best for you in your specific situation.