This is the ultimate question 99% of homebuyers struggle with. And if you are the average buyer, you’ll settle for the plain vanilla 5-year fixed (2 out of 3 Canadians end-up with it).
But why 5-year fixed? Is it because it’s what your parents always had, because that’s what everyone is advertising, because you don’t want to think about it for the next 5 years, or simply because variable sounds too risky…
Let’s be honest, these are not the most rational reasons. You are committing to the most important purchase of your life, and we believe it should be an informed one. Here is our best crack at the pros and cons of fixed vs variable, what misconceptions you should be aware of, and how to assess which one is right for you.
To put things in perspective, we will assume you’re buying a $400k property, with a 5% down-payment. Let’s do it!
What is a Variable Mortgage Rate?
With a variable mortgage rate, the % rate can vary over the term of your mortgage (a term usually lasts 3-5 years). The % rate will follow the banks’ prime rate.
Current best 5-year variable: 1.85% (prime -0.60%) (as of June 17th 2020)
What is a Fixed Mortgage Rate?
With a fixed mortgage rate, the % rate you pay will stay the exact same. Usually, a fixed rate mortgage tends to be higher than the variable rate.
Current best 5-year fixed: 2.09% (as of June 17th 2020)
How does it work?
8 times a year, the Bank of Canada meets to determine whether or not to adjust the overnight rate. Following the announcement, banks will adjust their prime rate. Your % rate will automatically reflect this adjustment (if any).
What kind of variation can you expect?
Over the last year(2020), the prime rate went down by 1.50%, landing on 2.45%. This means that someone who secured a variable rate with nesto in January 2020, is now benefitting from a rate that is 1.50% lower.
You guessed it, the rate you got initially doesn’t change. The downside for you is that banks are taking a risk by lending you money for a long period of time at a fixed rate, and they need to factor the risk and opportunity cost into the rate they offer you.
If rates go up during your term, they won’t make as much money as that could have by leaving their money in the market… To compensate, they will (always) maintain a slightly higher fixed rate to account for that risk. In a way, you are paying a little extra to make sure you don’t experience market changes in your payment, and also for the banks to protect/maintain their profit forecasts.
You will likely save from the get-go!
If the spread between fixed and variable remains the same, our couple will save $7,500 in the first 5 years. ($37,400 over the lifetime of the mortgage assuming the spread remains for 25 years). This represents a lot of money on a $400,000 purchase.
The other main advantage is the luxury of choice! Penalties for breaking a variable mortgage are much more reasonable than for a fixed mortgage. We will cover this point in detail below.
The ultimate peace of mind!
Don’t worry about anything, forget about all the economics, sleep sound knowing your rate will never change (up or down).
Note that peace of mind comes at a cost… If the spread remains, you will have paid more interest than you would have with a variable mortgage.
Most common misconceptions
“My monthly payments will fluctuate over time!?”
Not quite. With a variable mortgage rate, your monthly payments may change, or remain the same, depending on the lender. If your lender doesn’t update the payment, the amount of time required to payoff of the mortgage is extended when the rate goes up, and reduced when the rate goes down.
How is it possible? Some variable interest rate mortgages have fixed payments (ex: TD), but changes in interest rates affect how the payment amount is applied to the mortgage. For example, if interest rates go down, more of the payment goes to principal, and if interest rates go up, more of the payment goes towards the interest.
“I’m risk-averse, I want to protect myself: I prefer a fixed mortgage”
This will sound counter-intuitive, but know that you are taking on a very risky bet by choosing fixed: you will never break your mortgage – meaning sell your property, or refinance the mortgage within your term.
First, you need to know that most banks’ penalties on a fixed mortgage are astronomical. Second, it’s more likely than you think that people break their mortgage before the end of its term. You may move to another property, move in with your significant other, get a job in a different city, break-up with your partner (god-forbid), etc. The reality is that when it comes to mortgages, the average completed term is about 36 months (yep, that’s much less than 5 years).
What happens when you break your mortgage? With a fixed mortgage, you pay a significant penalty.
Penalties are calculated based on 3 months’ interest. This means roughly $2,500 depending when they break during the term.
On a fixed mortgage, you will pay a maximum of 3 months of interest or the ‘interest rate differential’ – meaning paying back the interest owed until the maturity of the term (often based on much higher posted rates)
If you break your mortgage after 1 year, your penalty would be $11,424.
Yep, that’s a lot! Note that any cash back or fees paid by the bank at time of closing will need to be reimbursed as well.
When are you losing?
When the Bank of Canada raises the overnight rate so much that your variable rate costs more in interest than the 5-year fixed rate.
Keep in mind that you will have saved for the entire time your variable rate was under the fixed. Only if the variable rate above the break even point, are you losing in this context.
You are starting at 2.85% (0.65% below the 3.5% 5-year fixed), you would end-up at 4.15% (0.65% higher than 5-year fixed). At that point, the benefits you collected early on have been offset by the extra interest you are paying.
When you break your mortgage early (before the end of the term).
You may move to another property, sell, move in with your significant other, get a job in a different city, break-up with your partner (god-forbid), etc.
When Bank of Canada does not raise the overnight rate at a fast pace – and a variable rate would have made you save more than picking a fixed rate.
Who is it for?
You care about saving money upfront. You want flexibility, and value the low cost option of breaking your mortgage early.
You can live with some uncertainty about the future, and won’t lose sleep over it.
You really don’t want to think about your mortgage for the next 5 years, and you’ll sleep much better knowing your rate is fixed. You are absolutely certain you will not break your mortgage during the term.
A sudden change in your mortgage payment could significantly affect your budget.
Our preferred strategy for a variable mortgage rate
Even if your variable rate is less than a fixed rate, set your mortgage payment at the same amount using a prepayment privilege.
Why? You will pay more of your principal balance from the beginning (meaning you will own more of your property faster). This will help you save a lot over time! The more you own today, the less interest you pay to the bank over the next 25 years.
If your budget permits, go for bi-weekly accelerated payments. You will pay slightly more every month, but no interest on the increase and it will end-up paying your mortgage almost 3 years faster, and save big in interest!
Our preferred strategy for a fixed mortgage rate
Really take the time to assess your own personal situation, and determine how likely you are to sell, or switch to a new property within the term of your mortgage. If this is a real possibility, then seriously consider a variable rate mortgage.
If your budget permits, also go for bi-weekly accelerated payments. You will pay slightly more every month, but no interest on the increase and it will end-up paying your mortgage almost 3 years faster, and save big in interest!