Interest Rates – Fixed or Variable

Should I go with a fixed rate or variable rate mortgage? This is a question you may be asking yourself if you are considering a purchase, a refinance, or if your existing mortgage is up for renewal.  Everyone is different in terms of risk tolerance, assets and income. What is right for one person, may not be right for another.

There are a few factors that can help guide your decision:

  • How long do I plan to be in this home? Is it a long or short term plan?
  • Can I sleep at night knowing that my interest rate can change?
  • Can I afford the payment fluctuations when the rate changes?

One of the key differences in choosing a fixed rate or variable rate mortgage is the penalty structure of each. Closed variable rate mortgages can be paid off at any time with a 3 month interest penalty. Fixed rate mortgages have a penalty that is equal to: the greater of 3 months’ interest or an interest rate differential (IRD). So, with a closed variable rate mortgage you have an excellent idea of what your exit costs will be if you need to sell or pay off the mortgage before the maturity date. The IRD is tougher to gauge because it will depend on how much time you have in your term, and what the prevailing interest rates are when you pay off your mortgage. The interest rate risk versus penalty risk, and IRD is discussed here in more detail.

With a fixed rate mortgage you can sometimes save yourself the penalty if you are porting your mortgage to another property you are buying. The bank in this case, is not losing interest from their original contract with you, so no penalty is charged as long as you are borrowing at least the same amount, and meeting any other criteria they have. Porting your existing mortgage is also attractive if your rate is lower than the current market rates. If you need more money than the balance you are porting, banks will often provide the extra funds by “blending” your rate or adding a separate segment for the new funds.

For more information on porting your mortgage, see our information page on Portability.

There are some situations when you can’t port your mortgage:

  • If you are selling your home, and buying a lot.
  • If you sell your home and your new purchase is outside of your current lender’s trading area.
  • If you no longer qualify based on your lender’s current lending policy.

What influences the Bank of Canada’s decisions with setting the Overnight (Prime) Rate?

  • Historically, the Bank of Canada has set interest rate policy around an inflation target range of 1 to 3%. With the last two prime rate increases (July and September 2017), the Bank moved the overnight rate up in anticipation of future inflation. Click here for a graph showing current and historical inflation figures.
  • Canada’s economic performance. An economy that is showing solid or rapid growth is an indicator of upward pressure. Poor economic performance is an indicator of downward pressure.
  • World events. Global economic conditions also play a role in the Bank’s rate setting decisions.
  • The Bank reviews and sets the prime rate 8 times in a given year.

Possible solutions:

  • Opt for a capped variable rate mortgage. Some lenders offer mortgages with a capped rate, where the interest rate will not be higher then a set percentage. The trade off with this type of mortgage is that the discount off the prime rate is usually not as high as the discount off a regular 5 year variable. Also ask if there is an automatic float down if the rate goes up, and then goes back down.
  • If you don’t like the idea of a variable rate mortgage, and want a fixed rate, but don’t want to lock-in for 5 years, consider a shorter term. If you feel like you want some rate security, and the ability to pay off the mortgage sooner than later, choose a fixed term that matches the length of time you think you will need the financing.
  • If you are still thinking you want a variable rate mortgage or are already in one, consider setting the payment higher. By setting the payment higher, you are paying off extra principal with each payment, which can help manage some of the risks of future interest rate increases. Before you do this, talk to your branch to find out what options you have if you need to lower the payment in the future.
  • If you are in a variable rate mortgage where your payment remains the same regardless of rate fluctuations, check with your branch to find out how much of your payment is going towards principal and how much towards interest. You may want to either pay a lump sum against the principal or increase the payment to make sure you are still paying off an adequate amount of principal.

If you have the financial strength to handle fluctuating payments, and you are comfortable with the risk of a changing rate, then variable may be the right choice for you, especially if you need flexibility with the timing of paying off your mortgage. If you are juggling the demands of a young family, are on a fixed income, or if you will lose sleep at night worrying about the rate changing, then perhaps a fixed rate mortgage is a better choice.

Remember that everyone has unique borrowing needs. The choice of a fixed rate or variable rate mortgage is yours to make based on what your needs are and what your risk tolerance is.