Choosing between a fixed or variable mortgage is a very important decision you’ll need to make when buying a home. Each option has its benefits and drawbacks, and understanding these can help you make an informed choice that aligns with your financial situation and goals. In this guide, we’ll explore the key differences between fixed and variable mortgages, how they react to interest rate changes, and what you should consider before making your decision.
Fixed or Variable Mortgage – Understanding the Difference
Fixed-Rate Mortgages
A fixed-rate mortgage offers a stable interest rate for the entire term of the loan, usually between 1 and 5 years in Canada. This stability means your monthly payments remain the same, regardless of changes in the market interest rates. This can provide peace of mind, especially in a volatile economic environment.
However, if market rates drop significantly, you won’t benefit from the decrease until your term ends, and you renew your mortgage.
Variable-Rate Mortgages
Variable-rate mortgages, on the other hand, have interest rates that can fluctuate based on your lender’s prime rate, which follows the policy rate set by the Bank of Canada. When the prime rate changes, your mortgage rate can go up or down. There are two types of variable rate mortgages, an ARM (Adjustable Rate Mortgage) where the payments go up and down with the changes in the market, and a true variable rate mortgage where the payments stay the same and the amortization adjusts up or down with the rate changes. It is important to talk with a broker about the pros and cons of each to decide what is the best product for you.
Historically, variable rates have outperformed fixed rates, offering savings over the long term. Furthermore, variable mortgages often come with a three-month interest penalty for breaking the mortgage, which is generally lower than the penalty for fixed-rate mortgages.
How Interest Rate Changes Affect Mortgages
Impact on Payments
As mentioned before, some will adjust your monthly mortgage payments directly, while others might change the amortization period—the total time over which you repay the loan. Most commonly, however, your payments will change with the interest rate, and your lender will notify you of any adjustments.
For those who want the benefits of a variable mortgage but prefer consistent payments, it’s possible to arrange this with your lender. This approach involves adjusting the portion of your payment that goes towards the principal versus interest, keeping the total payment amount the same.
How Much Does a 0.25% Rate Increase Cost?
When the Bank of Canada changes its rate, it typically moves in small increments of 0.25%. As a rough rule of thumb, each 0.25% increase raises your payment by about $13 per month for every $100,000 of mortgage owed.
For example, John has a $100,000 mortgage on a five-year closed variable rate of 3% (prime of 4% minus 1%) with monthly payments of $473. If prime rises 0.25% to 4.25%, his rate moves to 3.25% and his payments increase to $486, a difference of $13 per month. On a $400,000 mortgage, that same hike would mean an increase of about $52 per month ($13 x 4).
Breaking the Fixed or Variable Mortgage
Life is unpredictable, and many Canadians break their mortgage contracts before the end of the term. Approximately 60% of Canadians break their mortgages around the three-year mark of a five-year term. Variable-rate mortgages are often more flexible and come with lower penalties for breaking the contract. If there’s a chance you might need to break your mortgage early, a variable-rate mortgage could be the more cost-effective option.
Historical Performance and Flexibility
Historically, variable-rate mortgages have performed better than fixed-rate mortgages, providing lower interest costs over time. Another advantage of variable-rate mortgages is the ability to switch to a fixed rate during your term without incurring penalties. This flexibility can be invaluable if interest rates start to rise, and you want to lock in a stable rate.
Variable-Rate Mortgage Considerations
Many borrowers fear the possibility of rising rates with a variable mortgage. Each lender’s prime rate follows the Bank of Canada’s policy rate and drives variable mortgage rates. While significant jumps in rates are rare, even small increases can affect your payments.
For example, if you have a $100,000 mortgage at a 3% variable rate, a 0.25% increase in the prime rate would raise your monthly payments from $473 to $486. This incremental increase can be easier to manage than the potential shock of a large rate hike at the end of a fixed-term mortgage.
Before You Lock In a Fixed Rate: 3 Things to Know
Fixed rates remain the most popular choice for buyers across Halifax and Nova Scotia because the payment never moves during the term. Locking in without reading the fine print, however, can cost thousands of dollars later. Beyond the exit penalties covered above, here are three things every Nova Scotian should understand before choosing a fixed rate.
1. A fixed rate does not eliminate renewal rate shock
A fixed mortgage only freezes your rate for the term you choose, typically 3 or 5 years. When the term expires, the remaining balance renews at whatever the market rate is at that time. Homeowners who locked in rates of 1.5% to 1.8% during the pandemic lows felt this first hand, with large payment jumps at renewal. Variable rate borrowers adjust gradually as conditions change, so their budget adapts over time instead of absorbing one large increase at renewal.
2. Bond yields, not the Bank of Canada, drive fixed rates
Many buyers assume fixed rates only move when the Bank of Canada changes its overnight rate. That is how variable rates work, and they only adjust after the Bank’s eight scheduled announcement dates each year. Fixed rates track Government of Canada bond yields, which react daily to international markets, US Treasuries, inflation data and energy prices. That is why a fixed rate can change several times in a single week even when the Bank of Canada has done nothing.
3. Which option fits your situation?
A fixed rate is a good fit if:
- You have a strict monthly household budget and cannot absorb payment fluctuations.
- You are confident you will stay in the home for the full term without refinancing.
- Market swings cause you real financial stress.
A variable rate is worth considering if:
- You want the flexibility to break or restructure the mortgage with a capped three month interest penalty.
- You may sell, upsize, downsize or relocate within the next 1 to 4 years.
- You want the option to lock into a fixed rate later if rate trends shift.
Rate holds, shorter terms and portability
Most lenders will hold a fixed rate for 120 days (occasionally up to 130) while you shop or wait for closing. If rates rise in that window you are protected, and if they drop your broker can usually apply the lower rate before funding. A 3 year fixed term is a sensible middle ground for buyers who want payment certainty without a full 5 year commitment: 5 year rates sometimes carry slightly lower promotional pricing, but a 3 year term reduces your exposure if life changes or rates ease. Most institutional lenders also let you port a fixed rate and remaining term to a new home in Nova Scotia; if the new mortgage is larger, the lender blends your existing rate with its current rate on the additional funds.
When I help clients weigh these options I ask one question: if your circumstances change in three years and you have to sell or move, how much are you willing to pay to break the contract? If a multi thousand dollar interest rate differential penalty is not in your budget, a standard 5 year fixed may not be your best path.
More Than Just the Rate: Other Key Factors
Do Not Confuse Fixed With Closed
The words “fixed” and “closed” are often misunderstood. If a lender offers a five-year “closed” mortgage, you could actually be entering a variable mortgage where payments move up and down with the interest rate. In mortgage terminology, “closed” always refers to your ability to fully pay off the mortgage, not to how the rate behaves.
With a closed mortgage, you pay a penalty if you pay off the full balance before the end of the term. With an open mortgage, you can pay it off at any time without penalty. Almost every mortgage you will encounter is closed, since open mortgages carry higher rates in exchange for that flexibility.
Prepayment Privileges
Beyond the interest rate, consider the mortgage’s prepayment privileges. These allow you to pay off more of your mortgage without penalties, which can help reduce the overall interest you pay.
Convertible To A Fixed Rate
Almost all lenders will allow you to switch your variable rate mortgage into a fixed rate at any point during your term, without penalty. They will offer the respective fixed rate mortgage to match the remaining term of your mortgage.
Penalty Calculations
Fixed-rate mortgages usually come with higher penalties for breaking the mortgage early, often calculated using the interest rate differential (IRD). In contrast, variable-rate mortgages typically have lower penalties, usually calculated as three months’ interest.
Choosing the Right Product
It’s crucial to choose a mortgage product that fits your lifestyle and financial situation. For instance, if you’re in a job that might require you to move frequently, a variable-rate mortgage might be better due to its lower penalties for early termination.
Conclusion
Deciding between a fixed or variable mortgage requires careful consideration of your financial situation, future plans, and comfort with potential interest rate fluctuations. Both types of mortgages have their advantages, and the right choice depends on your individual needs and circumstances.
For personalized advice and to explore your options, reach out to Alex Lavender, your trusted mortgage broker. With expert guidance, you can make an informed decision and secure the best mortgage for your unique situation