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9 Mar

Variable or fixed rate – the million dollar question


Posted by: Aneta Zimnicki

Variable rate or fixed rate mortgage – the million dollar question:  I don’t think there is one blanket answer that is right for everybody.  Let’s examine this matter in more digestible chunks.

Before spending time obsessing with rates, a new borrower should first understand the fundamentals of variable rate and fixed rate mortgages. Have this discussion with a mortgage broker early in the mortgage planning stages.  This gives you lots of time to think about your risk tolerance and avoids any rush decision.  Because rates fluctuate, it is
worthy of repeating,  time should not be wasted on obsessing with rates. Wait until you are actively shopping for property or ready for refinance, then discuss the rates that are applicable to you and your specific situation.  

Increases and decreases in fixed and variable rates do not necessarily work in parallel.   Variable rate is offered in terms of a discount (or premium) based on lender’s  ‘prime rate’, so prime plus or minus ‘x’.  The ‘x’ is what is held constant during your mortgage term, the ‘prime rate’ is what makes the mortgage variable.   Lenders base their prime rate on Bank of Canada’s (BoC) ‘overnight rate’.  BoC meets 8 times a year, the overnight rate does not change outside of those times.  The rate in a fixed rate mortgage is held constant for the term of the mortgage.

The discount offered on a variable rate mortgage (VRM) is a pendulum that swings back and forth.  There have been times of deep discount (prime minus ‘x’) and then lenders turn the taps off and  offer the less favourable prime plus ‘x’.  If lenders want borrowers to go into fixed, they may make their variable rate offering less appealing. This can occur on a large scale across a majority of lenders (due to a shift in the economy or  lender competition), or more isolated, where a certain lender needs to meet their business goals and make a shift in their business.   Adding to the last point,  be careful of the narratives you read in media about rate, they can be based on a specific lender pushing consumers in a certain direction.

After understanding the pros and cons of a VRM, the fixed versus variable decision can be boiled down to examining the rate difference between the current fixed and variable rates offered at the time of your mortgage application.   The rate offerings will be further refined to the lenders that you are able to qualify with (applicable especially to investors, as applications get more complex),  that offer the mortgage features and flexibilities you want, and that work with your overall portfolio financing strategy.   Instead of talking about random rates, now your discussion is tangible and applicable to you.

Consider this rate difference as the ‘insurance policy’ you are willing to take, or forgo and accept the risk.  Although prime rate hasn’t increased in a number of years, in the most recent history, the rate increase has been in 0.25% intervals,  parallel with the BoC overnight rate increase. Conversely, there have been some recent drops in the prime rate, but not in parallel with the BoC overnight rate decrease of 0.25% intervals.  Lenders have chosen to give customers less, decreasing their prime rate by a smaller interval (for example, 0.15%).

There are a number of advantages of a variable rate. Typically, it is lower than a fixed rate offering at the time of mortgage application (and hopefully for a significant portion of your mortgage term). There are studies circulating the internet which show that over long term,  you win with variable rate (up for each person’s interpretation).  An additional win is if prime rate drops during your term, you reap the additional savings.   The interest penalty for a VRM is only 3 month’s interest, often significantly lower than the penalty for fixed rate mortgages (which is the higher of 3 month’s interest or a complicated interest rate differential calculation, see related blog here).  Investors should position themselves for flexibility, where possible. The lower penalty cost can allow for a viable exit before term end, if unexpected changes in business come up.

The main disadvantage of a variable rate mortgage is the risk of rate increase, to a point beyond your comfort level.  Increased rate translates to increased mortgage payment.  For an investor, this will eat into property cashflow, and potentially land you in negative cashflow territory, if an investment purchase or refinance is not stress-tested adequately.   If a significant portion of your investment property mortgages are variable rate, and you also hold open variable secured home equity lines of credit (HELOC),  you expose yourself to significant impact to your finances.

Qualifying for a VRM (and fixed term lengths lower than 5 years) is harder.  Depending on your situation,  and often as you increase your portfolio size (and corresponding debt load, in the lender’s eyes), you may be limited to fixed rate options with some lenders.    Also, for rental properties, some lenders do not offer VRM or the ‘discount’ is less, making fixed rate a better option.

Typically a VRM is offered in a 5 year term,  and occasionally 3 year term.  This may not match your timeline plan with the property (for example, selling or refinancing), if you are keen on avoiding mortgage penalty costs.

Most VRM products allow you to lock into a fixed rate during the term of the mortgage.  However, you have to take the rate that is offered at that time.  There is no absolute certainty what that rate will be, and your existing lender may not necessarily offer you the best rate as they already have retained a commitment from you for the entire mortgage term.  (There are better lenders in this arena than others, a mortgage broker can help navigate).   These future fixed rates and corresponding monthly payments could be higher than you are comfortable with.

A great strategy for a VRM is to make the same monthly payment as you would with a higher fixed rate.  In this way, if rate goes up you won’t experience payment shock, and you have paid down some of the principle, reducing your interest.

In closing, if you can’t sleep at night, there is nothing wrong with choosing a fixed rate.  It depends on what your priorities and risk tolerances are. What is important is to educate yourself on your specific options and make a decision based on that.