Variable-rate mortgages have been around for nearly forty years. Banks were first allowed to offer them as interest rates rose in the 1980s. During this time, lenders found themselves holding fixed-rate mortgages that cost more than the interest they were collecting from borrowers, which was not good for business. They began offering mortgages with interest rates that would fluctuate at the same pace as the prime lending rate, whether it increased or decreased. It was an arrangement that benefited mortgage lenders as rates increased and is also fair to borrowers when interest rates began to fall. That was exactly the scenario at the beginning of the pandemic. Variable-rate mortgage holders benefited from the Bank of Canada reducing interest rates lowering their mortgage costs, even if only temporarily.
No One Successfully Predicts Interest Rates
Despite economists' predictions and regular announcements by policymakers, it's hard to know whether interest rates rise, fall or remain the same over several years. Therefore, to make the added risk worthwhile for borrowers, variable interest rate mortgages are almost always lower rates than fixed-rate mortgages. In fact, over the past 25 years, variable rates have only exceeded fixed interest rates a handful of times and only for short periods. The 25-year average for variable-rate mortgages is more than 1% lower than the 25-year average for fixed-rate mortgages.
Why Do People Choose Fixed?
Well, mainly for the security and peace of mind. Fixed-rate mortgage payments that don't change during the mortgage term. So you can be sure that the payment you make in month one is the same as the payment you'll make in month twenty-four, thirty-six, or sixty - regardless of changing economic factors. For new homebuyers who are often pushing the limits of affordability, the stability of knowing payments won't change eases fears and increases confidence. If you are risk-averse and fear your financial future, you are more likely to choose a fixed-rate mortgage despite the higher borrowing costs.
The Benefits of Variable Rate Mortgages
The obvious advantage is the lower interest rate, at least to start. There is always the chance that if the prime rate were to increase dramatically and very quickly, you could end up paying more than the fixed-rate at some point in your mortgage term. However, this happens rarely. With the average variable interest rate about a percentage point less than fixed, you have a buffer of two to three rate increases (the Bank of Canada usually only raises rates 0.25 - 0.5% at a time) before you pay more than a fixed rate. If you were to calculate the overall interest costs over your mortgage term for both variable and fixed, even in a time of rising rates, the variable rate usually wins out.
Economic Factors Aren't the Only Source of Uncertainty.
Rising inflation is often a signal that interest rates are about to rise. Other factors, such as housing affordability or global events, can cause the Bank of Canada to consider raising rates. However, economic factors impacting the prime rate are not the only source of uncertainty that homebuyers face. You may suddenly find yourself needing to sell your home and break your mortgage. The penalty for breaking a variable mortgage is generally low, typically three months of interest. Fixed-rate mortgages often charge the difference in interest between the new and existing mortgage for the remainder of the mortgage term, which can add up to thousands of dollars more.
Because of the higher rates and larger breakage fees, fixed mortgages tend to be more profitable for lenders. So it is no surprise that almost 75% of mortgages in Canada are fixed. During the pandemic, variable mortgages spiked in popularity due to the ultra-low rates and high housing prices. However, now that the prime rate is rising again, many homeowners are locking in their variable mortgage, converting to a fixed rate.
Whether to choose fixed or variable, to lock in or ride out the rising rates is a very personal choice that includes your comfort level, finances and other factors beyond what we have discussed here. Before you make any decisions, speak to a mortgage broker who will help you understand the important considerations for your particular situation. No one can predict mortgage rates, including your broker, but they can help you make an informed decision about what to do now and for the long-term success of your mortgage.