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Key Highlights

•  Rate increases take up to a year to fully impact the economy
• Inflation can be persistent if rates are not increased
• Shorter-term fixed rates good option if borrowers believe that BoC has been effective in its fight to combat inflation

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Variable vs Fixed Mortgage in 2022-2023? Which is Right for You? 

A well-known 2001 study by York University Prof Moshe Milevsky reviewed fixed and variable mortgage rates between 1950 and 2000 to find that 90% of the time, borrowers saved when they took out a variable-rate mortgage versus a fixed-rate mortgage.  The other 10% of the time showed this to be true only sometimes and heavily depended on different factors. The study concluded that if the interest rates are low, the borrower is better off locking into a fixed rate.

Of course, the interest rate differential penalty on fixed rate makes this option only sometimes the most sensible one. Risks imposed by higher overall interest costs from carrying a variable-rate mortgage, especially during times of market volatility, make a fluctuating payment  not suitable for everyone. For this reason, it is always advisable to look at your financial situation holistically – no 2 borrowers at any given time will have the same factors affecting their risks, needs and goals concerning their borrowing or homeownership.

What is a Variable Mortgage Rate

A variable-rate mortgage provides you with a floating interest rate on the interest portion of your payment. Your lender’s discount is a static variance from the prime at the time you commit to your mortgage. However, over your mortgage term, your variable rate will adjust alongside the lender’s prime rate, usually based on a premium added to the Bank of Canada (BoC) key policy interest rate.

In a variable-rate mortgage, the interest component of your mortgage payment will adjust alongside your interest rate; your payment may not. There are two variable-rate mortgage types: those with static payments and those with variable or fluctuating payments. Static payment variable rate mortgages are known as variable rate mortgages (VRM). In contrast, variable rate mortgages with a variable payment, where the payment adjusts with changes in the lender’s prime rate, are more accurately called adjustable rate mortgages (ARM). Commonly, they are both known as variable-rate mortgages.

Pros & Cons of a Variable Mortgage Rate

At any given time that you arrange your mortgage, the interest rate on the variable-rate mortgage will be lower than the fixed-rate mortgage. With a variable-rate mortgage, the interest rate will fluctuate depending on benchmark rates, whereas a fixed-rate mortgage remains the same throughout the mortgage term. The most significant risk on variable-rate mortgages is that interest charged and interest paid can vary quite significantly if rates surge.

Although the payments can save you money on a variable-rate mortgage, as they have static payments, if interest rates should rise; however, this can translate to more interest paid during your term. Such as when your amortization increases quickly due to a surge in rates, as they have this year due to inflationary pressures. These kinds of rapid rate adjustments by the Bank of Canada (BoC) can put you at risk of over-amortization – especially if you signed up for a default-insured mortgage with less than a 20% down payment during the heights of property valuation.

The risk of over-amortization can easily be remedied by going with a fluctuating payment on your variable-rate mortgage, which is aptly called an adjustable-rate mortgage (ARM). The payment on the adjustable rate mortgage will adjust along with a change to your lender’s prime rate, making it easier for you to manage the amortization over the term of your mortgage. Unlike a variable-rate mortgage, adjustable-rate mortgages are not impacted by trigger rates or trigger points. A trigger rate occurs when the prime rate has surged so much that your mortgage payment is only going to compensate for the interest portion. A trigger point occurs when amortization increases so much that your balance owing on your mortgage is higher than the original amount you borrowed.

The most significant benefit of a variable rate mortgage is that the penalty is only 3 months’ worth of interest. This feature and cost make variable-rate mortgages a viable option for taking advantage of lower rates over your mortgage term by letting you renew to a fixed term. Unless you have a low-restricted option on your mortgage, generally, you’d pay about 3 months of interest as a discharge penalty, making it a very affordable option to lock into a fixed rate by shopping around and switching lenders.

What is a Fixed Mortgage Rate

A fixed-rate mortgage has a fixed interest rate for the entire mortgage term, meaning the total payment between your interest and principal components stays constant throughout your term. When the mortgage commitment is issued, your fixed-rate mortgage locks in the bond yield, which stays unaffected by the BoC’s overnight target to the key policy interest rate – providing predictable payments to the borrower as long over the whole mortgage term.

Pros & Cons of a Fixed Mortgage Rate

A fixed rate is beneficial for budgeting purposes and offers financial stability, given that mortgage payments always remain the same for the mortgage term. On fixed rates, you can lock your rate and payment for a given period – your term – which can usually range from 1 to 5, 7 or 10-year terms.

The fixed interest rate being offered to you most often during the market cycle, or historically, will be higher than a variable rate for your situation. Even though the fixed rate will provide you with a stable and predictable mortgage payment for years, it will come with a more significant “interest rate differential” penalty. 

A convertible option with a variable-rate mortgage lets you early renew your variable-rate mortgage to a fixed-rate mortgage – without penalty at any time during your term. Reciprocally this option does not exist, as you cannot renew a fixed-rate mortgage to a variable-rate mortgage. It is impossible to switch from a fixed to a variable without paying the penalty.

Fixed vs Variable: Is Choosing a Variable Rate Mortgage Better in 2023?

Even though rates are surging currently, and it may not make sense for you to lock in, these high rates are not long-term sustainable. Compared to the 1980s, there is 5 times as much public and private debt. What does that mean, exactly? Public debt is money borrowed by governments through increases in foreign exchange reserves or by issuing bonds to compensate investors for mortgages. Private debt is created by private individuals or corporations through borrowing and leveraging. 

In short, debt has radically increased since the 1980s and the chances of sustaining such an enormous debt load at these high-interest rates are insurmountable for long periods. Therefore, it is most likely that as soon as inflationary pressure is under control, the BoC is going to decrease its overnight target to the key policy rate – bringing variable rates on mortgages down once again.

Variable mortgages historically cost less than fixed mortgages

As mentioned earlier at the start of this blog, variable mortgages cost less than fixed mortgages. Professor Milevsky, in his study, was able to show from 50 years of empirical data on mortgages from 1950 to 2000, historically, 90% of the time, a variable-rate mortgage costs less than a fixed-rate mortgage. However, fixed-rate mortgages were a better option at about 10% of the time. 

How Bank of Canada Rate Hikes Impact Variable Mortgages in Canada

Whenever the Bank of Canada (BoC) changes its overnight target to the key policy rate this directly impacts the overnight borrowing rates for the chartered banks. In turn, this affects all the smaller banks, credit unions and mortgage finance companies who borrow their money indirectly through the chartered “big” banks or directly through the BoC. 

How High Can Variable Rate Mortgages Go Before Leveling Out?

In theory, the Bank of Canada can keep increasing the overnight key policy rate indefinitely, – thus affecting the prime rates at various lenders throughout the nation. However as previously reported, debt has exploded many folds since the 1980s and the impact of such a move would be exponential. As the key policy rate hit 3.25% back on September 7th, it has impacted the borrowing capacity of many in the country, while an additional 50 bps (there are 100 basis points, or bps, in a percentage point) increase in late October solidified a recession. Any further increases in the future will only make this recession’s landing harder.

The BoC will take a measured approach as changes to the prime rate could take time before reverberating through the economy – potentially up to 12 months. The first increase occurred in April of 2022 and could take up to March of 2023 to show its true impact on the whole economy. The BoC’s goal is to keep increasing interest rates until it effectively tames inflation by reaching its inflation target of 2% to 3%. Currently, economic experts are predicting that the overnight rate could increase up to 4.25%, which would mean another 50 bps increase is still yet to come. That could come in the form of one increase on December 7th or two evenly split 25 bps increases between December and next year – only inflation numbers will tell how this plays out.

Questions to Ask When Choosing a Variable Rate

Questions you should ask yourself if choosing a variable rate – how aggressive do you think that the BoC and the US Fed are likely to be in their goal of driving down inflation? What are the risks to your goals if rates keep increasing? Do you have the financial stability to weather more increases? Will it give you peace of mind to lock in now? The solution is different for everyone – so is the impact if the rates keep moving up or start heading down.

Before the supply and demand issue created by COVID-19 and those additional ones from the war in Ukraine, inflation and prime rate was historically low. We can expect rates to settle down if the central bank overcomes the current inflationary challenges. However, there is no guarantee of this happening, so it is prudent to review your risk with one of nesto’s commission-free mortgage experts to find the most suitable mortgage solution for you.

Does it make sense to lock in a variable rate in the mid-5% range?

One of the best reasons for considering a variable-rate mortgage is its convertibility factory – its ability to be locked into a fixed rate at any time without a penalty. Before locking in a variable-rate mortgage to a fixed one, you must consider why this makes sense. Mainly the stability it provides over the term with its predictable monthly payments so that you can eliminate the what-ifs in your budgeting practices during this time. What is the point of saving a couple of thousand dollars if you lose sleep over it?

Considering that variable rates are 100% impacted by the central bank, it is important to consider your expectations of the direction inflation takes carefully. You know that any changes to rates will take up to a year to work through the economy fully. Even the first key policy rate increase of 25 bps done in April 2022 will have effectively not gone through the whole economy until March 2023. Looking into a 5% range at this time, if you can even find it – means that you would be accepting this payment for the remainder of your term.

What rate increase would be too high for a variable-rate mortgage to make sense?

Economists are predicting that the Bank of Canada (BoC) could decide to increase the key policy rate up to 4.50%, which is 75 bps from today’s central bank rate of 3.75%. Implying that lenders’ prime rates would be at least 2.20% higher than they have always been. Our current 5.95% prime rate would jump to 6.70% – which would be a high rate for the economy to sustain for too long if it’s effective in bringing down inflation, then we would see a shift to lower rates.  

However, the incoming economic impact would be devastating if rates were to keep edging up. The stock market, alongside darling US tech giants, has a history of double-digit gains and has been viscerated since the rate increases began. Investors have shifted their poor-performing stock gains and turned to the high bond yields to provide some guaranteed returns. Thus further fueling damage to the stock market as the money stays expensive and fewer investors would be willing to invest for a return on high risk. Corporations would have to reduce borrowing capacities and production at facilities as people would lower their spending capacity.

Fixed vs Variable: Is Choosing a Fixed Rate Mortgage Better in 2023?

It is important to note once more that the central bank’s rate decision impacts variable rates. In contrast, fixed rates are driven by the bond market, which is bond traders impacting bond rates based on their perception of the course the central bank will take with variable rates. The current bond rates are based on bond traders’ anticipation of the variable rates in 6 months.

Generally, a variable rate can act as a hedge against higher rates if the forward outlook is a recession. Therefore, locking into a higher fixed rate at this time may not be the most suitable option, as the outlook of inflation brings in the likelihood of rates declining. Any advice on rates is generally based on historic data and experience. A double-dip recession like the one in the late 1970s, if repeated like that in the early 1980s, can turn any advice on its head.

Suppose rates should drop due to an as-expected recession. In that case, it may be wise to lock in, especially at rates hovering around the 2% to 3% mark – as this is substantially lower than the currently available fixed rates in the mortgage market.

Pros & Cons of a 2-3 Year Fixed Rate Mortgage in Current Market Conditions

In late spring of 2022, it may have made sense to lock into a shorter-term fixed rate as they were quite low compared to the 5yr fixed rate; however, as recently as a few weeks ago, the market has turned on its head and now shorter-term are once again priced higher than the longer-term 5yr rate. However, there may be an opportunity that could present itself again if the economy drastically slows down, which so far it has yet to indicate.

Renewing into a shorter term at this time would provide predictability, even though at higher rates. You could lock into another shorter-term rate at the end of your term. However, this expectation is based on the possibility that rates decrease if the rate cycle reverses when reduced too quickly – then you may end up locking into a higher rate.

Pros & Cons of a 5-Year Fixed Rate Mortgage in Current Market Conditions

The main benefits of locking into a 5-year fixed rate at this time would be the certainty and predictability of a stable payment and reducing your overall anxiety as less attention is needed for your mortgage.

Conversely, you’d be taking the risk of not having access to lower rates within your mortgage term by locking your payment to a higher fixed rate. For certain borrowers, specifically, those that recently bought a home with a default-insured mortgage, the risk to their capital is too high with the current variable rate situation, so it makes sense to lock their mortgage to a 5-year fixed rate and ride out the market cycle. Capital risk in variable-rate mortgages is due to trigger rates and trigger points affecting the mortgage principal, or the home’s equity.

Questions to Ask When Choosing a Fixed Rate

 Take a look at your own risk – and ask questions similar to those you would ask if selecting an investment. Is your risk high? Medium? Low? Do you have enough savings to withstand increasing payments if you stick with a variable rate? What excess cash flow do you have, and is it enough to carry higher payments if variable rates keep rising? What is the highest payment that you can carry? These questions and a review of your current financial situation with your mortgage expert will help you decide the best options.

Locking your mortgage at a fixed rate will certainly mean a higher mortgage payment. Still, it will provide peace of mind which can be a valuable reward during these very trying economic conditions. A fixed rate is a good idea if you’re willing to pay a higher payment for this reward. It makes sense to sleep on any hard decision once you have gathered all the information to complete a risk-based analysis of your situation.

FAQ

Final Thoughts: So, is a Fixed or Variable Rate Better? It Depends On Your Situation, But We Can Help

Deciding on a variable or fixed rate is a question of personal choice and risk appetite. And while variable mortgages have proven to be more cost-effective over time than fixed mortgages, some people prefer the certainty of having the same payment throughout the mortgage term.

It is recommended that you take time to speak with a mortgage professional to discuss your current financial situation as well as your short and long-term plans for yourself and your home.

At nesto, all of our commission-free mortgage experts hold professional mortgage designations from one or more provinces concurrently. We know our clients receive the best advice and care when they speak with our specialists that exceed the industry status quo. Does your mortgage professional have a mortgage licence?

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