We had a really big decision to make before we moved into our new house last summer.  Do we choose a fixed or a variable mortgage rate?  The answer varies for everyone depending on their financial situation and tolerance for risk.

According to the popular 2007 study by Moshe Milevsky, variable mortgage rates have saved home owners money nearly 90 per cent of the time.  Sounds like an easy decision then, right?  Not exactly.

This Time It’s Different

Interest rates are still at historic lows, but last year most experts were predicting an increase of at least 1 or 2 per cent over the next two years.  5-year fixed mortgage rates were under 4 per cent, which was an attractive rate to lock into and protect against the risk of future interest rate hikes.

But if the math favours variable mortgage rates, why are home owners so divided on this issue?

The vast majority of Canadians choose the 5-year fixed term.  Proponents of fixed mortgage rates enjoy the peace of mind knowing that their payments won’t change.  They also feel that we are in one of those rare situations where locking into a 5-year term will save home owners money.

Since variable rates are always initially cheaper than 5-year fixed mortgage rates, the decision ultimately comes down to saving money now vs. the potential of saving money in the future if interest rates rise.

What Options To Consider?

Let’s go back and look at the numbers that helped guide our decision.  These were the mortgage rates that were available us last summer:

  • 5-year variable mortgage rate – 2.20 per cent (prime minus 0.8)
  • 5-year fixed mortgage rate – 3.89 per cent
  • 3-year fixed interest rate – 3.54 per cent
  • 1-year fixed interest rate – 2.64 per cent

At the time, 5-year fixed mortgage rates had a built-in premium of 1.69 per cent over the best variable mortgage rate.  Still, a 5-year fixed term under 4 per cent is extremely low.

If the Bank of Canada decided to raise interest rates aggressively over the next few years, this would have been the better option.  On the downside, we would pay $260 more per month if we chose the 5-year fixed mortgage rate over the variable rate.

Economic Factors at Work

The Bank of Canada meets eight times a year to make interest rate announcements and historically will move the rate by 25 or 50 basis points at a time.  There is certainly the potential for interest rates to move between 2 and 3 per cent in a single year.

The problem is we’re terrible at predicting where interest rates are headed.  When it comes to monetary policy, there are a lot of moving parts to consider.  It’s not as simple as just trying to contain inflation or trying to prevent a housing bubble.

If interest rates were to rise sharply, the Canadian dollar would continue to climb vs. the American dollar, putting pressure on our manufacturing sector that relies heavily on exports.

Interest rates are at historic lows, but with the outlook of the world economy still very uncertain, it’s likely the Bank of Canada will continue to move cautiously to avoid triggering another recession.

The Affordability Factor

The debate over fixed vs. variable mortgage rates should be more about affordability than any other factor.  Can your personal budget handle a 2 or 3 per cent hike in interest rates?  If not, than the fixed rate gives you that peace of mind to know that your payments won’t change for 5 years.

On the other hand, if you can handle an increase in mortgage payments then you might find a great opportunity to save thousands of dollars in interest over the life of your mortgage by going variable.

We ended up choosing the 5-year variable rate, but with a twist.  We set our payments as if we were paying a 5 per cent interest rate.  This way we can knock years off the overall amortization of our mortgage while saving thousands of dollars of interest.

And we will still have the peace of mind knowing that we have built in a $600 per month cushion into our mortgage payments in case interest rates rise.

If you had to renew your mortgage today, what option would you choose?


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