Which is better, a variable or fixed rate?

To inform your choice, here's how these rates work.

Usually, depending on your situation, when getting a mortgage or renewing for your next term, you'll need to make a personal financial choice as to which mortgage rate is better for your goals — a variable or fixed rate.

Each of these rate types have fundamental differences in how they operate and what drives them. Let's take a look at these differences to help understand why the choice isn't always obvious.

To learn more about the pros and cons relating directly to your mortgage, check out our blog: Variable vs Fixed Mortgage Rates.

First, which mortgage rate is actually the most popular?

Usually, around 60% of our clients choose a 5-year fixed rate mortgage, versus less than 30% for a variable one. Fixed is the rate that your parents, and your parent’s parents, went with for decades. It essentially guarantees that your mortgage payments will not change for 5 years, which allows time to settle into a payment budget and know exactly how much is being paid down on your principal. A 5-year fixed is also the term that banks like to compete on, and so it often carries the best value.

How do banks set their 5-year fixed rates?

Canadian lenders set their fixed mortgage rates by looking at their own borrowing costs. Fortunately, their borrowing costs are relatively easy to follow, because they're linked to the fluctuations of Bank of Canada 5-year bond yields. Banks use bond yields to cover the costs they incur when financing mortgages.

• When yields are up, costs for banks are up.
• When yields are down, costs for banks are also down.
• Bonds trade daily, which means the 5-year mortgage rates can move at anytime.
• Mortgage rates don't move lock-step with bond yields, but have a spread-relationship that can help determine where rates may be headed.

Read more here: How are mortgage rates set?

So, when you choose a 5-year fixed rate mortgage, the bank or lender is essentially taking on all that daily-fluctuation risk for you.

Yet, a growing number of our clients are going with a variable rate mortgage.

Variable rate mortgages are riskier because they're tied directly to the prime rate — but are lower than fixed rates. During our recent period of historically-low rates overall, more clients are choosing to take the variable risk.

Variable rates are described as a 'discount off of prime':

• Depending on the lender, you'll be offered a variable rate that is prime minus a discount, usually anywhere from 0.3 to 1.55% off prime.
• The Bank of Canada (BoC) sets the prime rate, and adjusts it up or down in response to economic and financial conditions, pressures and forecasts.
• There are many factors involved in the BoC's prime rate decisions to move up or down, such as a heated economy, job numbers, inflation risks, world events (such as the recent global pandemic), and energy-price fluctuations.
• At rate announcements throughout the year, the BoC will provide reasons and analyses, as well as predictions on what may happen at future rate announcements.
• Sometimes, there is fair warning of increases, but sudden changes are also not off the table (increasing the variable-rate risk, especially if you're locked in to a term).
• Lenders occasionally break from the BoC decisions to raise or lower their lending rates based on their own financial pressures.

When you choose a variable-rate mortgage, depending on your length of term, you're the one taking on the rate risk for your payments to potentially increase.

How much lower are variable rates?

The typical difference between a variable rate and a 5-year fixed rate can be anywhere between 0.25 to over 1%. With that difference, some feel that it's enough to offset the added risk, and are willing to absorb the increased payments if rates do rise during their mortgage term.

Update Nov. 8, 2021: Right now, in fact, our variable rates are at an all-time low, with a difference over fixed rates higher than a 1.5% margin — leading to more of our clients choosing a variable-rate mortgage term than usual.

In a CIBC study done a few years ago, it was shown that 88% of the time, it paid-off financially to take a variable-rate mortgage over a fixed-rate mortgage.

So, which mortgage rate is best for you?

Your choice can come down to three questions:

• Can you sleep calmly at night, knowing the risks involved with a variable rate?
• Can your budget handle a 3 to 4 percentage increase in your mortgage rate (higher mortgage payments) if prime climbs dramatically?
• Do you plan to sell your property within three years, or want a faster way to pay down your mortgage?

To save more, or stress less? We can help you get your lowest rate, and the best fit for your situation. There's no cost or obligation. Give us a shout.