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Shopping For Mortgage Rates: Fixed Vs. Variable

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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30 Comments

  1. Michael O'Byrne on January 11, 2012 at 10:05 am

    I’ve never understood the rush to pay of a mortgage. Your mortgage loan is usually the cheapest way to borrow money. Instead of paying extra into it, consider putting the extra money into an investment – in many cases the best investment is in your own house.

    The physiological rush to “own my own home” is understandable but I suggest it is not the best approach from a financial point of view.

    My attitude is that the bank owns my home; I pay rent on it. I keep my mortgage payments low but, because the house is theoretically mine, I spend a lot keeping it maintained (to retain the value). I also spend money on keeping the running costs as low as possible (install the best and most economical furnace, water heater, windows, insulation etc.) These expenditures do not reduce my mortgage but they do reduce my cash outflow every month and make the house more comfortable to live in and if I ever sell the house they will increase my return.

    When I was with the Federal Government I saw a study that showed the average civil servant only drew his/her pension for three years. That made me realize that I should stop earning money with the aim of enjoying my retirement. So many of those people had spent their lives living with the aim of retirement only to die three years into it. Many had paid off their mortgages only to find that they were in an empty house.

    • Echo on January 12, 2012 at 11:13 am

      @Michael – I guess the term “rush” is pretty subjective. By increasing my mortgage payments, I’ve reduced the amortization to 15 years instead of 25. That’s still a long way away. For me, the key is to balance saving and investing while paying off the mortgage and still having a bit of fun today. It’s not easy.

    • Kyle Pearce on May 28, 2012 at 9:14 pm

      Hi Mike:

      You have an interesting view with respect to the common suggestion to pay off your mortgage faster.

      While interest rates are low, you’re right, you can possibly earn more on an investment. Unfortunately, in most cases, when interest rates are now, you probably aren’t taking the stock market by storm either.

      As a mortgage agent, I would always suggest to my clients to pay off their highest interest debt first and then work from there. If a client is left with a mortgage as their only outstanding debt, I would still suggest they pay-down their mortgage as well as invest. Adding an extra $100 a week can make a huge difference and motivate clients to make better financial decisions in the future when they see the years shaving off.

      Your ideas are definitely sound and as the saying goes, “To Each His Own” 🙂

  2. Scott Dawson on January 11, 2012 at 10:14 am

    Good post Echo. It should be noted however that since this summer discounts on Variable rate mortgages have disappeared. Prime minus .80% used to be the norm but now depending on the lender you’re looking at Prime minus .10 at best. On the other hand fixed rates have come down and a five year fixed is down to about 3.29%. This has had some effect on which products clients choose and the majority are moving back into the fixed rate products.

    You said it in your post, “The problem is we’re terrible at predicting where interest rates are headed.” And you’re right, there are too many factors that affect interest rates to make it possible to predict accurately.

    The only thing you can do is get into the right mortgage product for your personal situation, and it looks like you did.

    • Echo on January 12, 2012 at 11:13 am

      @Scott – thanks! It’s a much more difficult choice now when the spread between fixed and variable is so thin.

      Of course, now the experts are predicting the BoC will hold or even cut rates, which means the opposite is likely to occur 😉

  3. Steve @ Canadian Personal Finance on January 11, 2012 at 11:33 am

    I would stick with a 4-year fixed rate (around 2.99% at the moment).

    • Echo on January 12, 2012 at 11:18 am

      @Steve – that’s a pretty sweet rate!

      • Steve @ Canadian Personal Finance on January 12, 2012 at 11:19 am

        @Echo I currently have a variable rate for 2 of our places, but if we were to refinance I would be confident at a 2.99% 4 year fixed.

        I am pleased I stuck with variable since I became a homeowner over 5 years ago.

  4. Kevin on January 11, 2012 at 11:35 am

    We just went through the process of renegotiating our 5 year fixed mortgage. We found that, as Scott said above, the Variable Rate discounts are no longer there with 5 year Variable Rates now at around 3%. You must also see this Variable Rate change if you have taken out a Variable Rate mortgage. In my analysis, it becomes clear that the Banks and Government are very wary of the number of Canadian homes that are supported by Variable Rate mortgages. This is a very risky place to be, should mortgage rates suddenly rise, as there would be the possibility of many defaults on mortgages as people find it impossible to pay with the higher Variable Rates. This is why the discounts are not there. As a society, we are being “guided” towards 3-5 year fixed mortgages to “protect us” by the powers that be. Frankly, I think it is a good thing and makes our Canadian economy a little stronger.

    • Echo on January 12, 2012 at 11:21 am

      @Kevin – my variable rate hasn’t changed because I locked in at prime minus 0.8. It will only change if prime goes up.

      I don’t agree that variable rates are risky. This is not like the US sub-prime market with teaser rates that go up 5-6% in two years. Canadians still need to be approved at the 5-year posted rate.

      The banks are not guiding us into fixed rates to protect us; they simply make more money with a fixed rate.

  5. My University Money on January 11, 2012 at 9:11 pm

    Hey Echo, in my opinion the decision you faced wasn’t that difficult. I agree that we are terrible at picking long-term interest rates (maybe even worse than picking stocks!), but we are about as certain as we can be for the next 18 months or so. As you pointed out, there is no way we can raise interest rates with the USA flatly stating that they will remain rock bottom for at least another 18 months. This would absolutely cripple large parts of our country. After that 18 month period no one really has any idea, but interest rates would have to climb well over 5% for the rest of the term for the fixed mortgage to win out. There would have to a series of unbelievable events for that to happen given the current economic climate.

  6. Ellen on January 12, 2012 at 8:23 am

    Great article. When I bought my first house, I thought rates were low (5.55), but compared to now, that’s high! I went with fixed, just because my personality is such that I needed the stability and knowing exactly what I’d owe each month!

    • DV on March 12, 2012 at 11:06 am

      In my variable rate mortgage (2.1%) the total outgoing amount every month (EMI) remains the same even if the prime fluctuates. When asked how is that possible, my lender (a credit union) explained that though the EMI amount doesn’t change what does change is the Principal and the Interest component within that EMI. So with a variable mortgage I DO know what my fixed outgoing will be every month regardless of the Prime fluctuating.

  7. krantcents on January 12, 2012 at 11:10 am

    I would take the 5 year fixed because my balance is small and the slight difference in interest rate will not affect me materially.

  8. Juan on January 12, 2012 at 11:11 am

    It really can be quite risky to try and save that extra 1 or 2 percent by opting for that variable rate mortgage. Imo the peace of mind knowing that those monthly payments are fixed is worth that extra percentage point.

  9. Miss T @ Prairie Eco-Thrifter on January 13, 2012 at 9:03 am

    This article is so timely. My husband and I have been talking about this lately. A couple years ago we signed a 5 year mortgage for 3.75 which was a great deal.We traditionally are more variable people but the rates we really good. Same situation now. In fact we have emailed our broker to discuss resigning early to one of the 2.+ rates for another 5 years. I think when interest rates are this low, you can’t go wrong with locking in.

  10. Dave@50plusfinance on January 14, 2012 at 9:19 pm

    I have a fixed 5 percent mortgage and I’m happy to leave it alone. I could refinance to 4 percent but I selling in 3 years so I’m staying put. It all depends on your own story. I would never have a variable on a long term plan. I would variable if I was out before it resets. Use the variable to your advantage. A fixed rate gives me peace of mind. It works for me.

  11. The Passive Income Earner on January 16, 2012 at 5:38 pm

    I prefer variable rates or short fixed term – 3 years or less. The banks actually want you for a 5 year term 🙂 It must be more profitable for them that way …

    I find that if I have a 3 year term or less, I can more easily take advantage of the changes in rates by blending and extending. It doesn’t cost you anything to do that. The opposite is that it can be cheaper to break your mortgage if you needed to. I will admit that there are some very good 5 year rate these days.

    Personally, I look at paying the least amount of interest when I can. Sometimes breaking your mortgage will help you with that. The most important time to either increase your payments or ensure you have a low interest is early in your mortgage because everything is compounded.

    • Echo on January 18, 2012 at 8:57 am

      @The Passive Income Earner – I agree, the banks aren’t looking out for your best interests. They are pushing the five-year fixed because it’s the most profitable for them.

  12. The Passive Income Earner on January 16, 2012 at 5:42 pm

    I wanted to share this link about the 10 year history of fixed versus variable rates.

    http://www.canequity.com/mortgage_rate_history.stm

    • Echo on January 18, 2012 at 8:55 am

      @The Passive Income Earner – Funny, I was just reviewing that site for an upcoming article. Very interesting information. Thanks for sharing!

  13. Ryan Ducharme on January 23, 2012 at 1:33 pm

    Michael,

    I hear what you are saying, however, for me it’s all physiological. I am currently on a variable prime minus 0.8. I am “rushing” to finish off the remaining $250k on my mortgage for one reason only; piece of mind.

    When the world goes to hell in a handbasket, I want to be assured that I own my house and not the bank. I shudder at the thought of what’s going to happen in 10 years time when interest rates are back to “normal”. At that time hopefully I’ll own my house and I can relax a little knowing that no matter what I’ll have a roof over my head. So although I may make more money investing in Stocks, Bonds & Mutual funds, they are intangible and therefore can’t feed me or my family in a crisis. At least with a roof over my head I have shelter. I can always find food and clothing on a bare-budget.

    My 2 cents.

    • Common Sense - not that common on October 26, 2012 at 12:12 pm

      “When the world goes to hell in a handbasket” and it will… sooner than you think.

      I use the same reasonong. Prime – 0.9% and have been throwing all into my mortgage, I’m renew next January and will only have a $100K mortgage. Just like you, I want to be mortgage free and own my house before the next financial crisis hits…

      • Kyle Pearce on October 26, 2012 at 7:23 pm

        Once again, paying off debt is never a bad thing. But with a $100,000 mortgage remaining, I think you’ll be able to handle any curve balls that may be thrown at you over the next decade.

        If the world is going to hell in a hand basket as you and others suggest, then I would consider enjoying life now rather than being the only responsible one!LOL

  14. Tray on January 24, 2012 at 1:03 pm

    4 years ago I locked in at 5.7% at the time it was going up before the crash.. now I am thinking of breaking out of it. The penality however is $6,000 plus I only have one year left on the term. I can lock in at a new rate of 2.99% however I will have to add that fee to my mortgage amount.
    Do you think I should just wait one more year to see what happens? or cut my losses and do it now. I fear getting into a fixed rate again just because its so hard and expensive to get out of.. but the fixed rates right now are lower then the variable.

    • Ryan Ducharme on January 24, 2012 at 1:08 pm

      Tray,

      I am no expert, but I would say this:

      Depending what your remaining mortgage is it would be easy to calculate the savings. If you can make that $6000 back within the year, then I would say it would be worth looking at. However, I don’t believe the rates are going up to what they were pre-2008 anytime soon, so you might be just as well waiting out your term and refinancing at that time.

      Again, I’m no expert, but if the banks are offering 5 year terms at 2.99% that tells you something. It tells you that they know prime will stay low for quite some time and they are trying to lock in customers right now. Because of that (and again, I could be wrong) I am going to stay on my variable for quite some time to come. Historically variable has out performed fixed.

      my 2 cents.

      Ryan

    • Scott Dawson on January 24, 2012 at 1:41 pm

      Tray,

      If you spoke with a good mortgage broker they would be able to do the calculations for you to show if it was worth doing or not.

      I caution only considering rate however. The 2.99% that BMO is offering is highly restrictive with the terms and conditions so may not be in your best interest.

      Talk to a good mortgage planner.
      Scott

  15. Tray on January 24, 2012 at 1:57 pm

    I owe about 250,000 left CIBC has a attractive offer of 2.99 for 4 years locked in and a 2% cash back. So if I were to get the cash back and plug it back into my mortgage the switch would be worth it as I would only be out $1,000 in penality fee otherwise it wouldnt be worth the switch because my savings would only be in the $3,000 range and I would not make the $6,000 back.. Thing is I have a feeling the rates will go lower by the this time next year due to Euro and US doing bad.

  16. The Passive Income Earner on January 24, 2012 at 9:14 pm

    @Tray
    Discuss with your lender about doing a blend and extend. 1 year at your current term and 4 years at the new term. There is no penalty. I have done it a couple of times already (I take shorter mortgage terms to benefit from that).

    Also, competition is fierce so they may also match others in terms of mortgage rate. I know my bank matched the other offers.

    Best of luck!

  17. Alan Harder on June 28, 2014 at 7:13 pm

    I’m a mortgage broker, and both personally and professionally I prefer variable. It’s simply a better deal in the long term. However there’s one fundamental challenge I face when setting clients up with a variable mortgage.. Vancouverites simply can’t afford them.

    Currently the variable is Prime-55bps (2.45%) and the qualifying rate is 4.79%. With a 5-year fixed, buyers don’t need to worry about the qualifying rate, and can get in at ~2.99%.

    When somebody is trying to buy as much home as they can afford, that makes an absolutely massive difference in their decision process.

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