It’s essentially one of the biggest financial decisions you’ll ever make: what type of mortgage do you want? The problem is, up until you get a mortgage, you’ve likely had very little counselling about the two main options available.
Those options are either a fixed-rate mortgage or a variable-rate. Deciding between the two means taking a number of your own personal factors into account. But it’s also important to understand what’s going on in the market.
Below, we break down what you need to know and when you should opt for either a fixed or a variable-rate mortgage.
The difference between the two
First, it’s important to understand the fundamental difference between a fixed-rate and a variable-rate mortgage.
A fixed-rate mortgage means your lender gives you a rate that stays the same throughout the length of your term. A five-year term is the most common in Canada — meaning if you settle on a rate of say, 3.14%, then you will pay 3.14% on your mortgage for the five years until your term is over — at which point you’ll be up for renewal.
A variable-rate mortgage, on the other hand, can change with the market. It will often follow the lender’s prime rate — which is influenced by the Bank of Canada. If you get a variable-rate mortgage at 2.99% and the prime rate drops by 25 basis points, your variable rate will drop to 2.74%. Conversely, if the prime rate increases 25 basis points, your rate will rise to 3.24%.
You may have noticed in our two examples that the variable rate started off lower than the fixed-rate. Often times, you’ll be able to get a lower variable-rate — but the trade off is it comes with higher risk.
“When looking at the two, I always want to know what the client’s risk tolerance is,” says Nalie Nguyen, the Calgary-based executive director of Dash Mortgage.
She says if you’re the kind of person who’s going to lose sleep over the next few years because fluctuating rates cause you stress, then a variable rate might not be right for you.
What’s going on with rates?
Interestingly enough, in recent months, the traditional relationship between fixed and variable rates has inverted.
Variable-rate mortgages typically offer lower rates because they’re a bigger risk to you and less so to the bank — if a bank’s borrowing costs are lowered, they get passed on to you. And vice a versa. With fixed rates, if rates rise, the bank can’t pass those costs on to you.
Recently, however, it’s been common to see fixed-rate mortgages with lower rates than their variable counterparts. This is a very rare market phenomenon (more on why below). Right now, the best fixed-rate being offered on LowestRates.ca is 2.39% — while the best variable rate is clocking in at 2.64%.
To explain what’s going on, you need to look to the bond markets. Fixed-rates follow bond yields, which influence the cost of borrowing money. Bond yields signal in advance what market participants expect the Bank of Canada to do in the future. Right now, the bond market is signalling a drop in the BoC’s key overnight lending rate — but that hasn’t happened yet. So while fixed rates have dropped, variable rates won’t drop until the Bank of Canada actually cuts its key rate.
Or, in simpler terms: fixed-rate mortgages follow the bond market, variable-rate mortgages follow the Bank of Canada.
That means right now, going with a fixed-rate is the better deal — unless you’re very confident that the Bank of Canada will be cutting rates multiple times in the near future.
Which to choose
In the past 30 years, variable-rate mortgages in Canada have handily outperformed fixed-rate mortgages.
“On average, variable-rate has always outdone the fixed rate in the five-year,” says Nguyen.
That’s because bond yields have been on a multi-decade downtrend, which has benefited consumers (if you’re interested in learning more about why this is happening, this article is a good primer). Of course, past performance does not guarantee future returns.
One thing that Nguyen reminds borrowers is that lenders will allow those who hold variable-rate mortgages to convert to fixed before their term is up — although it comes with a cost. That cost is typically three month’s interest, or the interest rate differential (which is the difference between the interest rate on your existing mortgage and the current interest rate for a term that is the same length as the amount of time you have left on your existing mortgage term).
Breaking a term is actually fairly common — most Canadians break their mortgage contract within three years, says Nguyen.
“People’s lifestyles change — they think they’re going to live in that house forever, but then they break their contract to move into bigger house because they have a family.”
Alright, so now you know you’re not beholden to a fixed or variable-rate mortgage forever. So which do you chose?
If you’re in the market today (September 2019), then it’s clear that a fixed-rate is a better deal. You’re getting a lower rate and you don’t have to hope for the Bank of Canada to start cutting its key rate to lower your monthly payment.
But if you can stomach the risk, opting for a variable has historically paid off and many experts expect that the Bank of Canada is about to resume cutting interest rates.
Ultimately, it’s what you’re comfortable with choosing.
“I personally think a variable-rate is always better,” says Nguyen. “But if a client says, no they’re not comfortable with it, I’m not going to pressure them with the variable rate.”