Whether you're purchasing your first home or upgrading to a larger one, the fixed vs. variable mortgage decision is undoubtedly one of the most important.
You can save thousands of dollars over the life of your mortgage if you make the right choice.
So, which is better: a fixed-rate mortgage or a variable-rate mortgage?
This, like many mortgage-related questions, does not have a one-size-fits-all answer. Both mortgage types have advantages and disadvantages and work well in specific situations. Which one is best for you is depends on a number of factors, including the global economic outlook and your willingness to take risks.
- Mortgage contracts are usually either fixed rate or variable rate
- In a fixed-rate mortgage, the interest rate and payment are set in advance for the term
- In a variable-rate mortgage, the rate changes depending on the lender’s prime rate
What is a fixed-rate mortgage?
A fixed-rate mortgage is exactly what it sounds like: a loan with a fixed interest rate.
The lender cannot change the interest rate once you sign on the dotted line, regardless of market fluctuations. Mortgage interest rates are affected by the state of the economy. Low economic growth leads to low mortgage interest rates, whereas strong growth causes rates to rise.
So, how does having a fixed mortgage rate help?
To begin with, you know ahead of time how much interest you will pay over the life of your mortgage term, which is defined as the length of time a mortgage contract is in effect.
Second, because the interest rate is fixed, your monthly mortgage payment remains constant throughout the term (e.g. 3.75% interest on a 30-year fixed mortgage). Mortgage payments that are predictable and consistent make it easier to manage your finances.
- You can lock in a low interest rate for the entire mortgage term
With a fixed-rate mortgage, you can fully capitalize on periods of unusually low interest rates. Purchasing a fixed-rate mortgage at a low interest rate allows you to lock in a low rate for the mortgage term
It's important to note that fixed-rate mortgages have slightly higher interest rates than variable-rate mortgages. However, because it is difficult to predict how events will unfold years in the future, locking in a low rate for the next 15 or 30 years while it is available can be a wise strategy. In essence, a fixed-rate mortgage costs slightly more than a variable-rate mortgage in exchange for the assurance that your low interest rate will not be lost.
- Easier to plan and budget
Budgeting for a fixed-rate mortgage is easier because you know exactly how much your mortgage payments will be each month.
Tip: you can also save money protecting your home with life insurance instead of mortgage insurance.
- Protects from interest rates increase
A fixed rate can protect you from market fluctuations.
Remember: The lender cannot increase the fixed rate, no matter what happens to the prime rate offered by the Bank of Canada.
- Potentially higher overall cost
If the interest rates were to drop in the future, you will miss out on better interest rate deals.
- Higher break penalties
When you take on a mortgage, you commit to a strict payment schedule for a predefined period of time. Making changes to those terms early or prepaying the entire loan before its time is called breaking your mortgage. You will have to pay a mortgage breaking penalty regardless of the type of mortgage loan. The penalty is usually much higher with fixed-rate mortgages, typically by a few thousand dollars.
What is a variable-rate mortgage?
The name says it all. A variable-rate mortgage is a type of mortgage contract where the interest rate can increase or decrease during the term. But whether your mortgage rate goes up or down, the size of your monthly mortgage payment does not change. What changes is the part of your monthly payment that is applied towards the principal and the interest.
If the interest rate increases, the amount applied to the interest increases, meaning it will take more time to pay off the home loan. If the interest rate goes down, more of your monthly payment is used to pay off the principal.
Most lenders allow homeowners to switch to a fixed rate from variable at any time. You do not have to pay a penalty for the conversion, but must accept the fixed rate that your lender is currently offering.
How does a variable-rate mortgage work?
The interest rate of a variable-rate mortgage is based on the lender’s prime rate, which in turn is usually based on the Bank of Canada’s prime rate.
For example, you purchase a mortgage having a prime rate of -0.25%. Say, the lender’s prime rate is 3%, so you will start with a rate of 2.75%. If the lender were to lower its prime rate to 2.5%, your rate would fall to 2.25%. But if the prime rate were to increase to 3.75%, your rate would jump to 3.5%.
Regardless of what happens to the interest rate, your monthly payments will not change. However, a higher rate means you will take longer to pay off the loan. Conversely, a lower rate helps you repay the mortgage loan quickly.
1. The initial interest is lower
Variable-rate mortgages have an introductory rate, which tends to be lower than a fixed-rate mortgage. This rate lasts for a certain period, which may vary from one lender to another. Once the introductory period expires, the interest rate fluctuates depending on the lender’s prime rate.
A lower initial rate can make the mortgage affordable for someone on a tight monthly budget. And since the monthly mortgage payment remains the same throughout the entire term, they can be reasonably assured of not falling behind on payments.
2. It is easier to qualify for a variable-rate
A lower monthly payment makes qualifying for a variable-rate mortgage easier compared to a fixed-rate mortgage.
3. You can buy a more expensive home
If you have your heart set on an expensive home, a variable-rate mortgage may be a better option since you will be making lower monthly payments. Don't forget to also plan for mortgage insurance payments.
4. Minimal break penalties
Breaking a mortgage is cheaper with a variable-rate mortgage. Most lenders charge minimal penalties, usually not more than three months of interest.
5. Convert to a fixed-rate mortgage
If interest rates are rising and expected to continue to rise over the next few years, switching to a fixed-rate may save you a few hundred dollars a year. Thankfully, you can convert from a variable rate to a fixed rate at any time without paying a penalty. But be aware you will have to lock in the current rate offered by your lender — which may be higher than what other lenders are offering you — for the remainder of the term.
- You will pay more if the interest rate increases
If the rate goes up, your total mortgage cost could be higher than what you would have paid with a fixed-rate mortgage. And if your rate increases high enough, negative amortization might occur. Negative amortization is a situation in which the principal amount increases even as you pay regular payments. This happens when monthly payments cannot cover the interest you owe on the loan.
- Converting to a fixed rate could cost you more
You can switch from a variable rate to a fixed rate whenever you want. But you can do so only at the lender’s current fixed rate, which may be higher than the fixed rate the lender was offering when you first took the loan.
The Fixed vs. Variable Mortgage: A Comparison Chart
What should I do if I have a variable-rate mortgage and interest rates increase?
Let us say that your initial rate was 3.25%. Fast forward five years, and now you are paying a percent more. Naturally, you are worried. A home loan is a big expense and uncertainty around it is not comforting.
In this scenario, switching to a fixed rate can be an option, especially if you expect interest rates to continue rising (as part of a mortgage refinance).
Variations of fixed mortgages
Fixed-rate mortgages can be either open or closed.
Open fixed-rate mortgage
With an open mortgage, you can prepay the mortgage balance in part or in full at any time without incurring a penalty. There is no penalty for refinancing the loan or renegotiating its terms either. However, these perks come at a cost. Compared to closed mortgages, open mortgages have higher rates.
Open fixed-rate mortgages tend to have shorter terms, anywhere between six months and five years. They are not very common in Canada, but can be a right fit for borrowers who think they will be able to pay off the loan early.
Closed fixed-rate mortgage
A closed mortgage is more restricted and offers limited flexibility. You pay a penalty if the extra payments exceed a certain amount or if you pay off the loan early. Also, you cannot renegotiate the terms or refinance the loan without paying a penalty.
Variations of variable-rate mortgages
Variable-rate mortgages are of four types: open, closed, adjustable rate adjustable payment, and lock and roll.
Open variable-rate mortgage
You can make as many extra payments as you like, prepay the entire loan, or change its term without incurring a penalty.
Closed variable-rate mortgage
These plans offer limited prepayment options. Generally, you will be slapped with a penalty if the extra payments exceed a certain amount or you prepay the entire loan.
Adjustable rate adjustable payment mortgage
As your interest rate changes, your monthly payments will also change.
Lock and roll mortgage
Your interest rate and payment automatically changes every six months instead of every month.
Prepayment and Penalties
Most mortgage lenders offer borrowers certain prepayment options. Prepayment refers to making payments over and above the regular mortgage payments to pay off the loan faster.
Different mortgage contracts may offer different prepayment options. Depending on your mortgage agreement, you may be able to prepay 10%, 15%, or 20% of the original principal amount once every year. If you prepay more than the allowed percentage, you will incur a penalty — known as prepayment penalty or charge.
You will likely also have to pay a penalty if you:
- break the mortgage contract
- transfer the existing mortgage to another lender before the expiry of its term
- prepay the entire loan.
Each mortgage lender sets its own prepayment penalties and they are substantially higher for fixed-rate mortgages.
Mortgage agreements are of two types: fixed-rate or variable-rate.
With a fixed-rate mortgage, the interest rate is set in advance for the term. As a result, your mortgage rate and monthly payment remains the same throughout. Variable-rate mortgage has lower rates but offers less security: the interest rate may change regularly (though your monthly payment will not).
If you prefer a “set it and forget it” mortgage, a fixed rate may be the right fit. But if you want to go with the lowest rate on offer and do not mind taking a little risk, a variable-rate mortgage is a better option.
Frequently Asked Questions
What is the difference between a variable and adjustable-rate mortgage?
In the case of a variable-rate mortgage, your interest rate may go up or down depending on the lender’s prime rate. But your monthly payments do not change.
Like a variable-rate mortgage, an adjustable-rate mortgage has a floating rate, meaning it may rise or fall. However, the key difference here is that the monthly payments fluctuate with the interest rate. If the interest rate goes down, the monthly payment of your adjustable-rate mortgage will also decrease.
Fixed vs. variable mortgage — which one is better?
Both fixed and variable mortgages have their pros and cons, so it is not really that one is better than the other. As to which one you should buy, that largely depends on your appetite for risk and the state of the global economy.
Typically, a variable mortgage has lower rates than a fixed one. If you want the best possible deal and do not mind a rate increase, say, three or five years down the line, a variable-rate mortgage is right for you.
In contrast, if you are someone who doesn't like taking risks, locking the low rate available today for your entire mortgage term may be a better strategy. This is particularly true if experts predict high economic growth in the future — the stronger the economy, the higher the mortgage rates.
Should you switch from a variable rate to a fixed rate?
Whether or not you should switch to a fixed rate comes down to risk tolerance. If the mortgage interest rates are increasing and you are really worried, then locking in a rate that is slightly higher than what you are currently paying may be worth it.