Fixed or Variable Rate Mortgage: What’s the difference? What’s better?
One of the most common questions mortgage shoppers have when they start their mortgage search is…”should I go with either a fixed or variable rate?”. So – what’s the difference, and what’s better?
What is a Fixed Mortgage Rate?
A fixed mortgage rate enables you to “lock in” a predetermined rate for a set period of time (i.e. term). The most popular term is 5 years.
A fixed mortgage rate gives you a bit more comfort and security knowing what your monthly payments will be each month for the duration of your term. This makes financial planning and budgeting a lot easier.
What is a Variable Mortgage Rate?
A variable mortgage rate changes based on the mortgage lender’s prime rate. For example: if a lender is advertising a rate of -0.1 and prime is 3%, the rate would be 2.9%. In other words, your mortgage rate increases and decreases along with the prime rate.
Since prime can increase or decrease on a monthly basis – variable rates are not for the faint of heart. Anyone taking on a variable mortgage needs to be able to handle changes to their monthly payments not only financially, but psychologically as well. If the thought of paying an extra $200 in mortgage payments causes you to lose sleep, a variable rate may not be for you.
What is “Prime”?
Prime is the benchmark interest rate used by major banks when pricing for short term loans. Prime is directly influenced by the Bank of Canada’s overnight lending rate and can fluctuate on a monthly basis. Changes to both the BOC’s overnight lending rate and the prime lending rate are determined by current economic conditions.
Over the last 25 years, the Bank of Canada has:
- Made changes to the prime lending rate an average of 6 times each year (directly affecting prime rates)
- Each change to the rate has been by either 0.25% or 0.50%
- Year over year the prime lending rate has fluctuated by 1.23%
Fixed vs. Variable – Which is “better”?
The difference between the variable and fixed rates can be quite large, so is it always better to go with the lower rate?
Let’s compare a Fixed Rate of 3.99% versus a Variable Rate of 2.05%, both on 5 year terms. The interest difference between the two is 1.94%, so what would the difference in payments be? If we look at an average $250,000 mortgage amortized over 25 years, that turns out be a difference of $249.03/month or $2,988.36/year!
Comparing a fixed rate to a variable rate is really like comparing apples to oranges. Security has a price (as does everything!), meaning that you’re always going to pay a premium for the security of having a fixed mortgage rate. If having steady payments is important to you, think of it as buying a bit of insurance.
So…which is “better”?
A few studies have been done in the past trying to figure out which option saves you the most money. The largest study was done by Dr. Moshe Milevsky, Associate Professor of Finance at York University’s Schulich School of Business, using data from 1950 to 2007 (keep in mind that this also means that 10% of the time mortgage holders would have saved money by choosing a fixed rate mortgage).
90.1% would Save Money with Variable Rate
The average Canadian would save 90.1% of the time by choosing a variable-rate mortgage instead of a fixed.
Average Savings was $20,630
Over 15 years per $100,000 borrowed.
The Gist? Security has a Price…Most of the Time
Variable rate mortgages have typically been a better choice for Canadians over the last 25 years and over the long run, homeowners can end up paying extra for a fixed rate – but this isn’t always the case.
The spread between fixed and variable rates can sometimes narrow, and when it does consumers find it increasingly difficult to gamble on a variable rate. Consumers experienced this at the beginning of 2012 which marked a time when major banks and other lenders were pricing mid-term mortgage rates (3 to 5 year fixed) below prime!
What’s “better” in the end is a combination of your personal tolerance, and the current conditions in the mortgage market. If you’re unsure on which would work better for you, it’s best to talk to a mortgage expert who can help you determine which product will best suit your current needs.
- Fixed Mortgage vs. Variable Mortgage
- Why do Mortgage Rates Change?
- Your First Mortgage
- How to Get the Best Mortgage Rate
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