With so many questions about choosing a Fixed vs Variable Mortgage, here’s a simple list of helpful mortgage facts.

The gap between variable rate mortgage and fixed rate mortgage products has narrowed in recent years. Fixed rate mortgages offer certainty in a monthly payment, but can be a slightly higher rate than a variable rate. A variable rate, on the other hand, would be the riskier of the two mortgage choices due to the chance of an increase during the term – so what do you choose, a fixed or variable mortgage? 

Your income, lifestyle and risk tolerance will weigh heavily on your decision, but your ability to qualify will inevitably determine which mortgage product suits your circumstances. To qualify for a variable rate mortgage, you must qualify using the Bank of Canada Benchmark rate (currently 4.74%) rather than the contract rate, which is how you would qualify for a Five Year fixed mortgage (currently around 2.49%). So your income needs to be sufficient for the additional two-plus percentage points, regardless of your risk tolerance or preference.

Risk versus reward

The appeal of variable rate mortgages (VRM) and / or adjustable rate mortgages (ARM), is that the interest rate is typically lower than that of fixed rate mortgage products. Although that spread has decreased over the years. Even with the initial lower interest rate, the main drawback is the risk involved. Without warning, interest rates could increase or decrease.

An easy way to decide if a variable rate mortgage product is right for you is confirm whether or not you can afford an increase is your interest rate. Run a scenario with rates increasing 25 basis points and 50 basis points. You should still be comfortable with the payments

Another way to determine if a variable rate mortgage product is right for you is to assess your current income and earnings, and what, if any, is the potential for increases. You are looking to assess if it is likely that your earnings will increase to help you deal with any interest rate increases.

Understanding the risk involved with variable rate mortgages is a prerequisite.

If you’ve decided you can afford a variable rate mortgage, and you qualify, the next thing you will want to determine is if a variable rate mortgage fits your personality. If you’re the type of person who will have trouble sleeping at night knowing your interest rate may go up, even slightly, a variable rate mortgage may not be the best option for you.

One thing you can do to mitigate risk and reap the rewards of choosing a variable rate mortgage is to fix your mortgage payment at an amount higher than the minimum requirement. That way if rates increase they should still below what you are already paying.

A great strategy with a variable rate mortgage is to fix your payment at the current five-year fixed rate (or higher). Not only will you have a buffer if rates rise, but it will also allow you pay down the principle faster.

Also, while it may seem like a good idea to take advantage of a variable mortgage for a lower rate, and then switch to a fixed rate mortgage if and when your rates begin to rise, it may not be that simple. While most variable rate mortgages offer the ability to ‘lock-in’ if you want to, you need to know what the ‘lock-in’ terms are. Some lenders allow lock-in at best rates, some lock-in at posted. That can make a big difference, and may eliminate any benefit to locking-in. When you lock it in, you convert it from a variable rate to a fixed at the time of conversion, and if variable mortgages rates are increasing it’s very likely that the fixed mortgage rates have also increased. You likely won’t have a lot of luck in timing the market. 

Generally, variable rates are based off of prime (currently 2.70%), usually they are prime minus, but they have been prime plus (line of credit are prime plus), and even the minus has fluctuated over the years. You need to focus on the difference between what the rate would be with a variable and what it would be with a fixed. If the spread is less than 25 basis points, your discount could be gone with one rate announcement. The Bank of Canada meets eight times per year to set their policy rate, which is what prime is based on, and the Bank of Canada, when it increases rates, usually only increases in 25 basis point increments, but they could increase by 50.

Variable mortgage rates have historically been very popular in Canada. But the change in qualifying has really forced a pendulum swing, because a lot of people who may have wanted a variable rate mortgage no longer qualify for one. The other factor has been the narrowing of the difference between a variable rate and a fixed rate. With not much rate savings being offered, the decision in taking a fixed rate mortgage is almost a no-brainer.

For instance, at the moment, a typical variable rate time can be found at prime minus 0.35%, meaning a rate of 2.35%, and a fixed five-year rate can be found at 2.49%, making the spread only 14 basis points. With this spread, the risk versus the reward is not substantial enough, in my opinion, to take the risk on a variable rate. The Bank of Canada is very likely to raise its policy rate 25 basis at least once in the next five years. Typically, when fixed rates are within a percentage point of variable rates, fixed is the way to go.

While most people are risk-averse, a fixed rate mortgage can also provide budget certainty for first-time buyers, buyers beginning a family, or those growing their family.

Flexibility

While rates are important, the features offered in a mortgage should be the biggest determining factor for you when choosing your mortgage product.

The ability to put lump-sum payments down on your principal is what’s usually referred to as prepayment privileges. Banks and lenders differ on the amount usually ranging from 15% to 20% of the amount owed. Be sure to check the frequency because some lenders only allow this payment to be made once per year, which may not be convenient for you. So, if they allow you to prepay $10,000, and you opt for $5,000, you won’t be allowed to pay off another $5,000 in the same year. Lump-sum payments are traditionally annualized, meaning you can’t skip a year and then double it the next year.

You may want the flexibility to put down large lump-sum payments if you receive a bonus through work, a tax refund, an inheritance or just come into some extra money.

A simple way to take advantage of pre-payment is rounding up payment, if your payment is $1,423 roundup to $1,450 or $1,500. You won’t feel it in your budget, but that extra $27 (or $77) is going to pay down your principal that much faster.

You may also want to see if you have the option to increase your payments. With some products you can increase your payment by 10% to 20%, and some even allow double-up payments.

If there’s a possibility that you’ll move before your mortgage term is up, you’ll want to consider a portable mortgage product. Not all mortgages are portable. If you have to break the mortgage to move, what sort of penalty will you incur?

Penalties

The standard penalty to pay out a fixed rate mortgage is generally the greater of three months’ interest or interest rate differential (IRD), whereas a variable rate mortgage is almost always just three months interest.

Three months’ interest is simple enough, assuming a $300,000 balance at 2.69%, three months interest penalty would be about $2,017. 

IRD can be a lot more complicated to calculate, as not all lenders calculate it the same way. Basically what the lender is doing is charging the interest difference on the mortgage when compared to what they would get at the time the mortgage is ‘broken’. Some lenders will calculate it using the contract rate you are paying and compare it to the rate offered for the remaining term. Other lenders will calculate it by adding back the discount they provided upfront, essentially using the posted rate, and will compare it their ‘best’ rate for the term remaining, this can add thousands of dollars to a payout penalty. Far more cost than any savings you might’ve gotten from the lender in interest rate, and most of these lenders aren’t offering the best rates anyway.

 For example, let’s say you had a mortgage from a year ago with a rate of 2.69% and a balance remaining of $300,000, using a four year rate of 2.49% and your contract rate of 2.69%, your penalty would be approximately $2,400, which is greater than the three months so this is what you would pay.

Now let’s look at a lender that would add back the discount they offered and base the penalty on the posted rate available at the origination of your mortgage , your penalty would now compare the 2.49% for the four years remaining to the 4.64% posted, and your penalty would be $25,800! That’s a substantial difference.

 It’s important to talk with a mortgage professional when thinking about getting a mortgage; we can help you navigate the mortgages offered to help find the best one for you, whether it’s a fixed mortgage, a variable mortgage, or one that offers you the most favourable terms.

Co-written with Martin Breeze, Mortgage Broker, TMG The Mortgage Group