Fixed vs Variable Mortgage Rate Guide

Mortgages in Canada come in 2 main types, fixed rate and variable rate. At any point in this official mortgage rate type guide you can jump to a section:

A fixed rate mortgage is a fixed term that will have a locked-in rate for the duration that you enter. The downside to this type of mortgage is that the penalty can be greater if you need to break it before the end of your term.

A variable rate mortgage has the ability to move up and down over the term. What the lender is guaranteeing you is a discount on prime. For example, if you have a prime – 1% mortgage and the prime rate is 4% today, that means that your rate is currently 3%. If the prime rate drops down to 3.5%, then your rate will drop to 2.5% and vice versa.

The words “fixed” and “closed” tend to be misunderstood, so it is worth delving into these in further detail. If you hear that a lender is offering a five-year “closed” mortgage, you could actually be entering into a variable mortgage where your payments could move up and down with changes in the interest rate. Whenever you hear the word “closed” in mortgage terminology, it is always referring to the ability to fully pay off your mortgage.

With a closed mortgage you will have a penalty to pay off your mortgage in full before the end of the term, with an open mortgage you can pay it off at anytime without penalty.

Almost every mortgage that you will encounter will be a closed mortgage as open mortgages are used only in very specific situations. The key word you need to look out for is “fixed”. A fixed mortgage is one that will not move and will stay the same over the term.

Ensure that you don’t overlook this seemingly minor detail as you may in fact be getting yourself into a variable mortgage when you thought you were getting into a fixed.

Deciding between fixed and variable mortgage rates starts with knowing that different lenders treat rate changes in their own way. So you must ask what will happen if rates go up or down? Some lenders will increase or decrease the monthly mortgage payments and some will not change the payments and instead increase or decrease the amortization (life) of your mortgage.

However, the most common path is that your payments will change with the interest rate, the lender will notify you, and the next payment schedule will be adjusted accordingly. If you want to share the benefits of a variable mortgage but keep the consistency of the same payment, you must advise your broker of this so they can align you with the appropriate lender.

Almost all variable mortgages carry a three-month interest penalty, so it’s more cost-effective if you ever need to break the mortgage. If you think that you could potentially break the mortgage over the term, then I would highly recommend a variable-rate mortgage.

It is worth noting that roughly 60% of Canadians break their mortgage at the three-year mark of their five-year term. Life throws so many unexpected events and challenges our way, so a variable mortgage can be very beneficial. It is also worth noting that, historically speaking, variable mortgages have performed better than fixed-rate mortgages for borrowers.

Additionally, if you have a variable-rate product, almost every lender will allow you to switch over to their respective fixed rate during any period of your term. The fixed rate will be determined at the time you are looking to switch, using the lender’s current rate offering for that product. If you have a fixed-rate product, you will not be able to switch over to a variable-rate product during your term without breaking the mortgage and incurring a penalty.

Different market conditions may make one option more favourable than the other at any specific point in time.  It is a good idea to have this discussion with your mortgage broker to discuss the pro’s and con’s of each option along with the current rate environment.

I completely understand the concern that one may have with a variable-rate mortgage where their payments could increase, but even with a fixed-rate mortgage, you are not protected—see below for further details.

Many of us fear the variable-rate mortgage because we know it may increase beyond our control. The prime interest rate, also called the overnight rate, is set by the Bank of Canada. This is the rate at which financial institutions borrow funds at the end of the day to ensure their books are balanced. This rate directly influences the prime rates that the banks charge, and almost all of them have the same rate as one another.

When the Bank of Canada changes their rates, they typically do so in small increments of 0.25%. A common fear amongst borrowers is that interest rates are going to double and their payments will soar into the thousands overnight. This type of jump would be so incredibly rare (unless you have a massive mortgage, as it’s relative).

Just think what would happen if the interest rate spiked massively in the economy for our heavily indebted country. Defaults would run at such a high level amongst all borrowing categories that it would trigger a financial collapse. Let’s use an example to better illustrate this.

John has just obtained a mortgage for $100,000 on a five-year closed variable rate of 3% (prime (4%) – 1%) with a 25-year term. His monthly payments are $473 per month. The next day, the prime rate increases 0.25% to 4.25% and John’s rate moves up to 3.25% (4.25%-1%).

His monthly payments then increase to $486—a difference of $13 per month. This means that, as a rough estimate, for every $100k of mortgage owed, the payment will go up by $13 per month for each 0.25% increase. So, for instance, if you had a $400,000 mortgage, you would be looking at an increase of $52 per month ($13 X 4).

The biggest thing you need to understand here is that you are not protected from rate increases even with a fixed rate mortgage. This is because your term will always come to an end. If rates have increased in the market from when you first received your mortgage, you will need to renew at a higher rate.

Would you rather have the sticker shock of renewing one day with an increase of $200 a month, or would you prefer to incorporate those increases gradually through four $50 increases over the length of your term? 

Rate is not everything, but this tends to be the most common focus. Beyond rate, there a multitude of factors that need to be considered first, such as pre-payment privileges, collateral charge or conventional charge, variable or fixed, closed or open, etc. Using a broker to help understand your exact situation and align you with the perfect lender is far more important than rate.

Say, for example, you just got a mortgage and you were able to secure the absolute lowest rate of 1.94%, while everyone else was offering 1.99%. Your mortgage broker offered you a rate of 1.99% for a five-year fixed through a monoline lender.

She explained that this was the perfect product for you because you wanted to have the security of a consistent payment that would not change (fixed mortgage). Your broker was also aware that you could be relocated at any time and you may have to sell the house, which would mean incurring a penalty.

Due to this, your broker aligned you with a monoline lender because she mentioned that if you break the mortgage, the penalty would be much lower than through a bank.

The next day, you go to your bank to take the money out of your RRSP (Registered Retirement Savings Plan) and mention it is for a home. The bank’s mortgage specialist comes in and you start chatting. You told him that you just received 1.99% with your broker and he said he would have no issue getting an exception for you at 1.94% if you get the application in and approved today.

You take advantage of the savings of $3 per month on your $200k home and everything goes smoothly, you purchase the home. Two years later, sure enough, you receive the confirmation that you are being transferred and you need to sell your home.  You find a buyer and the house sells. 

On the day of closing at the lawyer’s office, you notice a penalty of $6,000 for breaking your mortgage early!  You think back to the conversation you originally had with your broker.  If you had been aligned with a monoline lender, the penalty would have been closer to $1,000 due to the way these two different lenders calculate their penalties. This is just an example to show that rate is not the most important aspect of securing a mortgage—the product itself and the foresight to ensure you are in the right mortgage is.