The main difference between a fixed rate and variable rate mortgage is that the interest rate you pay on a variable rate mortgage fluctuates based on the prime rate.
| Fixed Rate | Variable Rate | |
|---|---|---|
| Interest Rate | Remains the same during the entire mortgage term | Might vary during mortgage term based on changes in the lender’s prime rate |
| Prepayment Penalty | Equivalent to the greater of three months’ interest on the existing principal and interest rate differential | Equivalent to three months’ interest on the existing principal |
| Key Benefit | Stable payments with no risk of increased interest charges | Cheaper rates, resulting in less interest paid over the mortgage term |
| Key Risk | High rates can be costly in terms of interest charges | Rising rates, resulting in increased interest charges |
What is a Fixed Rate Mortgage?
The interest rate you pay remains the same throughout the mortgage term with a fixed-rate mortgage.
Each payment is identical in size, with a specific percentage applied toward the principal and interest.
Is It Right for Me?
A fixed-rate mortgage is ideal if you value stability and predictability.
It facilitates easy budgeting and provides peace of mind, as your payments will never increase unexpectedly.
A fixed-rate mortgage shields you from the risk of having to pay higher interest charges, should rates rise.
Sometimes, opting for a fixed-rate mortgage could be a wise choice based simply on the broader economic conditions.
For example, if interest rates are at historic lows, it’s only a matter of time before they start to climb.
Naturally, this would be the optimal time to lock in a favourably low rate for an extended period.
Fixed-rate mortgages are usually more expensive than variable-rate mortgages.
Servicing large mortgage payments could prove challenging if you have a tight budget.
In addition, they often come with a hefty prepayment or early break penalty.
Suppose you anticipate breaking your mortgage contract before your term expires.
In that case, you might want to think twice about committing to a fixed-rate mortgage.
Fun Fact!
According to a report released by the Mortgage Professionals Canada association, 74% of mortgages issued in Canada in 2019 were of the fixed-rate variety.
What is a Variable Rate Mortgage?
With a variable-rate mortgage, the interest rate assigned in your contract can fluctuate during your mortgage term.
These fluctuations will either increase or decrease your total interest costs.
The interest rate on a variable-rate mortgage moves up or down based on changes in the lender’s prime rate.
The prime rate, in turn, is heavily influenced by the Bank of Canada’s target for the overnight rate, which is the rate financial institutions charge when lending to one another.
For most variable-rate mortgages, the payment amount you contribute remains the same – what changes is the portion applied to the principal relative to the interest on your outstanding balance.
Should rates rise, a lower percentage of each payment will get applied against the principal, resulting in a more expensive mortgage over the long run.
Conversely, should rates fall, more of your payment will go toward the principal, meaning you’ll incur fewer interest charges over your mortgage term.
Did You Know?
When it comes to variable-rate mortgages, some lenders offer a variable-rate payment option, which means the size of your payment will vary throughout your mortgage term based on changes in the prime rate.
Is It Right for Me?
The primary benefit of a variable-rate mortgage is that it’s typically cheaper than its fixed-rate counterpart.
Historically, lenders have offered lower rates to borrowers who opt for a variable-rate mortgage.
This however comes with the risk that in a rising rate environment, you potentially end up paying a higher interest rate since you did not lock in a low 5-year fixed rate say a year or two ago.
Should interest rates drop, you could realize substantial savings in interest charges and accelerate the pace at which you pay down your principal.
Variable-rate mortgages also have less stringent prepayment penalties, an attractive attribute if you may be selling your home or paying out your mortgage before the term ends.
You should steer clear of variable-rate mortgages if you consider yourself risk-averse and don’t want to be saddled with potentially steep interest costs.
Gradual upticks in the prime rate will lengthen the time required to pay off your mortgage principal entirely, with an ever-greater portion of your payments allocated to interest charges.
Fixed Rate vs Variable Rate: The Math Behind It
Below are two tables that illustrate how a difference of just 1% on your mortgage interest rate can impact your payments.
Here, we assume a five-year term beginning on January 1.
Numbers have been calculated using the BMO mortgage payment calculator, rounded to the nearest dollar.
1. Low Variable Rates
| Fixed Rate | Variable Rate | |
|---|---|---|
| Mortgage amount | $800,000 | $800,000 |
| Interest Rate | 5% | 4% |
| Monthly Payment (25-year amortization) | $4,653 | $4,208 |
| Portion of Payment to Principal Month 1 | $1,354 | $1,563 |
| Portion of Payment to Interest Month 1 | $3,299 | $2,645 |
| Total Principal Paid Over 5 Year Term | $91,940 | $103,569 |
| Total Interest Paid Over 5 Year Term | $187,230 | $148,921 |
2. High Variable Rates
| Fixed Rate | Variable Rate | |
|---|---|---|
| Mortgage amount | $800,000 | $800,000 |
| Interest Rate | 5% | 6% |
| Monthly Payment (25-year amortization) | $4,653 | $5,118 |
| Portion of Payment to Principal Month 1 | $1,354 | $1,168 |
| Portion of Payment to Interest Month 1 | $3,299 | $3,950 |
| Total Principal Paid Over 5 Year Term | $91,940 | $110,939 |
| Total Interest Paid Over 5 Year Term | $187,230 | $225,801 |
Converting a Variable Rate Mortgage to a Fixed Rate Mortgage
If you hold a variable-rate mortgage and feel uneasy about the prospect of rising rates, you can ask your lender to convert it to a fixed-rate type.
Luckily, the conversion process doesn’t involve you paying any extra costs.
However, your lender will typically assign you their posted rate for your remaining term.
This rate is usually above what you’d be ordinarily entitled to receive, which means your interest expense can increase substantially.
Another option is to break your mortgage contract and switch to a new lender that can offer you a favourable fixed rate.
But keep in mind this entails paying a prepayment penalty equivalent to three months’ interest on your existing mortgage principal.
In addition, you might be responsible for paying a discharge fee, which could set you back several hundred dollars.
Frequently Asked Questions
- Is a variable rate mortgage a bad idea?
- Should I do a fixed or variable rate?
