Fixed Rate Mortgage Versus Variable Rate Mortgage

Fixed versus variable mortgages, where do I begin?

In general, my preference is variable and has been most of my life, especially if one has an excellent understanding of the economic environment.  

However, there are times when it makes more sense to take the fixed rate. But it comes down to one’s personal risk tolerance. 

If you have a high risk tolerance and financial capacity, then variable may be preferred. But if you’re risk averse and lack a high level of financial capacity, it may make more sense to take the fixed rate. Then you do not have to worry about rate movements for the next 3, 4, or 5-years.   

Financial Capacity

When I’m referring to financial capacity, I’m alluding to both income and liquid assets.  These both allow for your ability to absorb payment increases due to rate movement.  

Variable Rate Mortgages (VRM) are based on the Prime rate, which is set by the Bank of Canada. In most cases, it’s a set formula such as Prime - .5%.  

When taking a 5-year VRM, the formula is fixed during this term. Most VRMs have a convertible feature which allows for the VRM mortgage holder to convert their VRM to a fixed term.  

There are two catches, the first being that the fixed term has to be at least as long as the remaining term or longer of the VRM. If you have a VRM with 3.5 years remaining, your options become a 4 or 5 year fixed term. The second catch is that you will be subjected to the rates in effect at the time you initiate the conversion to a fixed mortgage, so in essence today’s rates, not the rates in effect at the time of advancement.

Fixed rate mortgages are set relative to the bond market. If you have a 5-year fixed rate mortgage, your rate is set for the 5-year term regardless of what happens to rates.

The benefit here is that your payments don’t change, and if rates climb during this timeframe, you can make pre-payments which are applied directly to the principal. This reduces the principal balance at maturity, reducing the impact on payments with the future higher rates that you would be renewing into.

Risk Assessment Example

What I have come to understand over the years is that many people override their natural risk assessment when rates are low, or the variable rate is more attractive than a fixed rate. 

A perfect example is what we witnessed a few years ago and now the resulting rate environment where the VRMs are priced at about 50 – 60 basis points lower than a fixed-rate mortgage.  

• One basis point equals one-hundredth of one percent, or 0.01%.

On average, an insured VRM is priced at Prime - .75%.

• Prime = 4.45%

• VRM Rate = 3.70% 

• Fixed Rate =4.29% 

• Difference = 0.59%.  

These are rates for an insured mortgage.

The benefit is a reduced monthly mortgage payment, with each payment having more applied to the principal. 

The Issue

The issue is that when the Bank of Canada (BoC) moves rates, they generally move at .25% at a time. We have seen this rate jump by .50% and .75% in the recent past, when the government advised us of “transitional inflation.” 

Unfortunately for the VRM holders, inflation wasn’t transitional.  

The “out” is the ability to convert to a fixed rate. However, the problem is that the bond market is fluid and moves daily, unlike the BoC, with set adjustment dates. They are more reactive and managed by fund managers whose sole job is to anticipate the BoC movements and, in many cases, are about two to three months ahead of the Bank of Canada.

You would need to have a keen understanding of the economic environment that we’re in and moving towards. This is the fuzzy part, as most of us are too busy to watch the markets daily.

What I Would Recommend

When people ask me what’s the best rate, the analogy I make is “how much would you spend on a yellow car?”  

You haven’t expressed what your financial objectives are related to this mortgage, such as flipping it, keeping it as your forever home, or using it as an investment property, so I’m not sure how to answer this question.

Would you pay the same price for the yellow car if it’s a 1972 Datsun B210 or a 2020 Ferrari?  

I would strongly recommend that when considering a VRM or fixed-rate mortgage, you first need to assess your risk tolerance and understand your capacity. What is your tipping point if the BoC is on a rate-increasing trajectory?

What most people missed in the last BoC announcement was that while they held Prime, they are preparing for consecutive rate increases. This doesn’t mean that they will raise rates, but they are preparing for this.  

There are other options available to you as well if you need to make a change in your VRM. 

Some lenders will allow you to split your mortgage into both a VRM and fixed rate. 

However, in many cases these lenders don’t offer rock-bottom pricing. 

There are other options available to you at renewal time, such as extending the amortization to reduce the monthly payments. Renewal time is also a great time to reassess one’s financial objectives to ensure you’re tracking or need a reset. 

This is where I come in so we can have an in-depth conversation relative to your objectives and determine whether the VRM, fixed, or combination mortgage is right for you.