Fixed and Variable Rate Loans: Which is Better?
When deciding between a fixed-rate and a variable-rate mortgage, it really depends on your financial situation, risk tolerance, and long-term plans. Both options have their advantages and trade-offs.
Fixed-Rate Mortgages
Advantages:
Predictability: Your monthly payments remain consistent throughout the term, making it easier to budget.
Stability: Especially useful if you expect interest rates to rise or if you want to avoid any uncertainty in your payments.
Long-Term Planning: Ideal if you’re planning to stay in your home long-term and want to lock in a good rate for several years.
Disadvantages:
Higher Initial Rate: Fixed rates are generally higher than variable rates to compensate for the security of locking in a rate for several years.
Limited Flexibility: Early repayment or refinancing might come with penalties, making it less flexible if you want to make changes to your mortgage.
Fixed-Rate Mortgages and Compound Interest
Interest is Compounded Regularly: For most fixed-rate mortgages interest is compounded on an annual or semi-annual basis, not monthly. This means that interest is calculated once or twice a year, but your payments are still typically monthly.
How Payments Are Applied: On a fixed-rate mortgage, a set portion of each monthly payment goes toward paying off the interest first, and the remainder goes toward the principal (the amount you originally borrowed). Even though you’re paying off interest, the interest is compounded regularly, so each month, the balance of the loan grows slightly by the interest charged, and then the principal portion of your payment reduces that balance.
The Impact of Compound Interest: Compound interest means that interest is added to the principal at regular intervals, so you’re effectively paying interest on both the initial loan amount and the interest that has already accumulated. However, the key difference with a mortgage is that it’s usually not compounded monthly like on a credit card or personal loan.
When to Choose a Fixed-Rate Mortgage:
- If you’re planning to buy a home and don’t want surprises in your monthly payments.
- If you value predictability in your budget, especially if you have other financial responsibilities that require steady monthly payments.
- If you are looking for long-term stability and are worried about rising interest rates.
In this case, you might prefer locking in a rate that won’t change over time, even if you pay a little more at the start.
What Influences a Fixed-Rate Mortgage:
The Canadian bond market plays a crucial role in influencing fixed-rate mortgages, primarily through the yield on Government of Canada (GoC) bonds. Lenders use these bond yields to determine the rates they offer on fixed mortgages.
- Fixed-rate mortgages, especially 5-year fixed rates, are closely tied to the 5-year GoC bond yield.
- When bond yields rise, fixed mortgage rates typically increase.
- When bond yields fall, fixed mortgage rates usually decrease.
Lenders fund mortgages by raising money from various sources, including bond investments. Since GoC bonds are considered very low-risk, lenders use them as a benchmark to price mortgages, adding a spread (profit margin) on top of the bond yield.
Key Factors That Influence Bond Yields (and Therefore Fixed Mortgage Rates):
Bank of Canada (BoC) Policy: When the BoC raises or lowers its key interest rate, it indirectly influences bond yields.
Inflation: Higher inflation leads to higher bond yields, which pushes up mortgage rates.
Economic Outlook: In times of economic uncertainty, investors buy bonds for safety, lowering yields and reducing mortgage rates.
Global Markets: Economic conditions in the U.S. and worldwide can affect Canadian bond yields, influencing mortgage rates.
Variable-Rate Mortgages
Advantages:
Lower Initial Rates: Variable rates often start lower than fixed rates, which can mean paying less interest, especially in a stable or decreasing rate environment.
Potential Savings: If interest rates stay the same or drop, you could save money over time compared to a fixed-rate mortgage.
Flexibility: In some cases, if interest rates drop, your monthly payments can decrease without any action on your part.
Disadvantages:
Uncertainty: Your payments may fluctuate if interest rates rise, which could strain your budget if rates increase significantly.
Risk of Rising Rates: If you’re in a period of rising rates (as we saw in recent years), your payments could increase substantially.
Variable-Rate Mortgages and Interest
Interest Calculation: Most variable-rate mortgages in Canada are based on prime rate (which changes with the Bank of Canada’s key interest rate) plus a margin (like prime + 1.00%). The interest is typically calculated on the outstanding balance of the loan.
Simple Interest vs. Compound Interest: For variable-rate mortgages, interest is typically simple interest rather than compound interest. This means that you’re only charged interest on the remaining principal balance, and that interest doesn’t compound over time.
However, interest is calculated monthly based on your current balance, but you’re not being charged interest on the interest (which is what happens in compound interest loans).
Adjustments with Rate Changes: With a variable-rate mortgage, the interest rate can fluctuate based on changes in the prime rate, which means that your monthly payment could increase or decrease depending on what happens with interest rates.
When to Choose a Variable-Rate Mortgage:
- If you can handle some uncertainty in your payments and are confident that interest rates will stay stable or drop.
- If you’re willing to take some risk in exchange for the potential of paying less interest over the life of the mortgage.
- If you’re planning to pay off your mortgage quickly and can handle the potential for fluctuation without stressing about higher payments.
In this case, you could benefit from a lower initial rate and possibly save on interest if rates stay low or decrease.
What Influences a Variable-Rate Mortgage:
The Bank of Canada (BoC) policy rate directly influences variable-rate mortgages because these mortgages are tied to a lender’s prime rate, which fluctuates based on changes to the BoC’s rate.
The BoC sets the overnight lending rate, which is the interest rate at which banks lend money to each other.
When the BoC raises the policy rate, banks increase their prime rate (the rate they offer to their best customers).
Since variable-rate mortgages are usually priced at prime minus a discount (e.g., Prime – 1.00%), any changes to the prime rate affect borrowers’ mortgage payments.
- BoC raises rates → Prime rate goes up → Variable mortgage rates increase → Higher mortgage payments.
- BoC lowers rates → Prime rate goes down → Variable mortgage rates decrease → Lower mortgage payments.
Key Factors That Influence Bank of Canada Rate Decisions (and Therefore Variable Mortgage Rates):
- Inflation: If inflation is too high, the BoC raises rates to cool spending and borrowing.
- Economic Growth: If the economy is slowing, the BoC may lower rates to stimulate borrowing and investment.
- Global Events: Recession risks, oil prices, and U.S. Federal Reserve policies can impact BoC decisions.
Final Thought: Ask Yourself These Questions
Can I afford higher payments if rates rise? Am I okay with potential penalties if I break my mortgage? Do I believe rates will go up or down in the next few years? How long do I plan to stay in this home?
Knowing your situation and risk tolerance and speaking to a Mortgage Broker when deciding between a fixed-rate and a variable-rate mortgage is a smart move. Brokers provide expert advice, access to multiple lenders, and personalized solutions based on your financial situation.
