The Great Debate: Fixed or Variable Rates?

For as long as I’ve been in the mortgage world it’s a question that sets hearts racing and tongues wagging with some being firmly on the variable side while others say it’s fixed all the way.

Long story short – we’ve been in a historically low-interest-rate environment for the last decade-plus, meaning that if you chose a Variable Rate way back in the day with a decent discount off of prime rate, then it’s more than likely that you’ve saved on interest costs.  That said, if you took a Fixed Mortgage rate in the last 10 years that’s been anywhere under 4% I say that you’re still ahead of the game (and if you’re not convinced just ask your parents and grandparents what they had to pay on money from the late 70s right through the mid 90s).

Spoiler Alert…there is no right answer and it ultimately comes down to personal preference as there are pros and cons to each type of rate.

First, let’s make sure we’re clear on what Fixed and Variable means.

FIXED– a pre-determined rate for a set period of time (i.e. 2.09% for 5 Years)

VARIABLE – a fluctuating rate based on prime rate or a discount off of prime for a set period of time (i.e. prime minus .80% for 5 Years)

Keep in mind that this is different than Closed and Open.  To learn more about the difference between closed and open check out this post https://www.valleymortgagebroker.com/blog/a-peek-inside-the-penalty-box-understanding-mortgage-breakage-costs

Variable Rate Pros:

-Can result in some significant interest savings if the Bank of Canada maintains (or decreases) the prime rate

-Can result in paying off your mortgage faster if your payments are set and the prime rate decreases (as more $ is going toward the mortgage principal)

-Breakage penalty is known in advance (generally 3 months interest)

Variable Rate Cons:
-If the Bank of Canada increases the prime rate, you can potentially pay more over the life of the mortgage

-Increases to prime can result in your mortgage amortization increasing (and you paying it off slower) if more of your payment is going toward interest costs and your payments aren’t automatically increased

-If you decide you want to convert your Variable rate to a Fixed rate (most lenders offer this) there’s a good chance the fixed rates that were available before are gone and you’ll be looking at higher rates to lock-in

Fixed Rate Pros:

-Your payment is firmly set and your exact amortization (paydown) schedule is known with no fluctuations

-In an increasing rate environment securing a longer-term low rate protects against future interest rate increases

Fixed Rate Cons:

-Fixed rates (generally speaking) are higher than Variable rates, so you are essentially paying a premium for the security

-Fixed rate mortgages can be subject to a higher breakage penalty (usually the higher of 3 months interest or Interest Rate Differential) which can be thousands of dollars more than you’d incur than with a variable term

If even the smallest of changes stress you out or cause you to lose sleep then considering a Fixed rate term might be the best bet, but if you’re okay with a little uncertainty or more importantly if the future is in any way uncertain for you then the variable might be the best way to go.

For example, if you think you might want to sell in a year or two and travel the world, then a 5 Year Fixed term probably wouldn’t be the best option as you could end up with a pretty steep penalty cost.

Your time horizon is a very important factor to consider because if you know for a fact you’re going to want to sell in a year locking yourself into something Fixed could limit your options. Sure, you could choose a 1 year fixed term, however, even in this case, the variable might be the better option.

Why?  Because unless you know that you’re going to sell in exactly 12 months the fixed might be ok, but if it actually turns out to be 14 or 16 months then you’ll have a mortgage sitting in an expensive open term once it matures.  A Variable rate term would allow you to take advantage of the discount off prime for whatever period between now and when you decide to sell would be, while still keeping the penalty cost low.

So what’s the current environment like?  As of the date of this article, the housing market in BC is on fire with seemingly untapped demand, and fixed rates have just increased over the past few weeks in step with the bond market.  Lenders seem to be much less generous with their fixed offerings, and on the flip side are offering deep discounts on variable terms (i.e. prime minus 1.00% to as much as 1.20% off in some cases).

We haven’t seen discounts off of prime like this for a while, and it’s this writer’s personal opinion that institutional lenders are anticipating a quicker economic recovery from the pandemic than first thought, and in turn anticipating shorter-term increases to the prime rate. For example, when the pandemic first hit you would have been lucky to find a Variable rate term at prime minus a half amongst all of the uncertainty but now it’s raining big prime discounts.

That said, there are many economists who have predicted that the prime rate will remain unchanged over the next 12-18 months or longer, which is entirely possible, but what it does in the long term is the real question. 

There are tons of videos online that speak to the benefits of variable rates from an average rate perspective, and this is definitely something to consider. For example:

Variable rate:

Let's say we went with a lender offering Prime - 1.00% = 1.45%

1.45% 6 months of 2021

1.45% for 6 months of 2022 (increase mid 2022 by 25 points)

1.70% for 6 months of 2022 (increase leading into 2023 by 25 points)

1.95% for 3 months of 2023 (increase by 20 points)

2.15% for 3 months of 2023 (increase by 25 points)

2.35% for 6 months of 2023 (50 point increase early 2024)

2.85% for 6 months of 2024 (increase by 20 points)

3.05% for 6 months of 2024 (increase by 25 points early 2025)

3.30% for 12 months of 2025 (increase by 50 points early 2026)

3.80% for 6 months of 2026

In the above example you’d end up with an average rate that’s somewhere in the 2.50% range, and it is also important to keep in mind that as rates potentially increase, your outstanding balance is declining so the argument is that it should all balance out in the end.

That said, could the prime rate increase more sharply? Absolutely. Or could it stay low/unchanged throughout most of your term? Also, yes. I think that more important than the rate itself is to look at the fluctuations above and ask yourself if this is something you'd be comfortable with, or if changes like this would cause stress? If your answer is the first then the variable can be a great strategic option, if the second there's no harm in staying fixed.

The bank rate is at the historically lowest point it's ever been, so it kind of feels like the only way for it to go is up - but it's ultimately a question of how quickly that's going to happen and what your comfort level with uncertainty is.

Having worked for a big bank for over a decade, I just find it hard to believe that these lenders would knowingly erode their margin (that’s basically the difference between what you pay them as a rate and what their costs are to administer the mortgage) by offering such deeply discounted variable rates unless they believe they’re going to make up that forgone interest in the long run.  But I am most definitely not an economist, there is no magic crystal ball, and even the uber-smart and seasoned economists seem to disagree half of the time.

So if you take anything away from the above I hope it’s a) rate type is a personal preference first and foremost and b) we are still in a period of historically low rates – fixed or variable – so you’re winning either way.  Borrowing money at 2 or 3 or even 4% is still cheap money, and this is something that I think we’ve lost perspective on as consumers due to the low rate environment we’ve been living in for so long. 

Questions?  Let’s talk.