Fixed or variable rate mortgage: is rate the only thing to look at?

One of the biggest questions you’ll face when planning your mortgage, is whether to lock in to a fixed rate or choose a variable rate mortgage. Currently, the 5 year fixed rate is just over 4%, depending on your credit score, purchase price, and whether the mortgage is insured or not. The same mortgage could be set up with a variable rate that ranges around 2.60% – 3.50%.  So how do you decide if a fixed or variable rate mortgage is better for you?

You can save money going variable, but not 100% of the time

Studies by financial experts such as Dr. Moshe Milevsky of the Schulich School of Business suggest that, more than half the time, you can expect to save money by going variable. Depending on how you look at the numbers, 65-80% of the time you would save money. BUT, and this is a very big “but”, the studies that show these savings were conducted in the predominantly falling rate environment we’d been seeing up until the last few years. Lately rates have been dropping again after a sharp rise over the last couple of years, and might be on their way down further, according to most experts. And of course, mortgage rates are impossible to time perfectly or to predict with 100% accuracy.  It’s just like trying to time investing in the stock market.  So how do you decide?

Points to consider when deciding on a fixed or variable rate mortgage

1. Run some financial scenarios, or have a mortgage professional help you to run some.

What I typically discuss with my clients is whether they’re okay with the prime rate rising 1-2% over the next five years. Then we calculate what that would do to your variable rate mortgage payments, and the amount of interest that you’ll pay, versus locking in.

2. Set your payments as if you’ve chosen a fixed rate mortgage, but go variable.

This enables you to pay down the principal much faster, decreasing your amortization (the time it takes to pay down your mortgage to zero). If rates do go up, you’ll be paying a higher rate, but the amount you’ll owe will be smaller, so the negative impact is smaller.

3. Have your cake and eat it, too.

Several lenders have a mortgage product that allows you to lock in a portion of your mortgage in a 5 year fixed, but keep the other portion variable. This gives you the best of both worlds and allows you to hedge your bets. You can always lock in the variable portion later if there’s a nice drop in rates, or, conversely, if you believe that rates are about to hike up.

4. Consider your real estate plans.

Might you be paying off your mortgage early?  Or are you likely to be moving, or doing anything where you might need to break your mortgage term early? If that’s the case, you might be better off with a variable rate mortgage. Your prepayment penalty is limited to 3 months’ interest, rather than the “interest rate differential” that is applied on fixed rate mortgages.

5. Evaluate your risk tolerance.

This is a big one. If choosing a variable product means that you’ll be stressed and unable to sleep at night because you’re worrying about the mortgage rates, then it’s not worth the potential savings!  You are allowed to convert your variable rate mortgage to a fixed rate at any point during your term.  But, the rate is generally not as favourable as what you’d be offered initially.  If you think you’ll be tempted to obsessively watch mortgage rates with your hand on the “convert-to-a-fixed rate” trigger, then just go with a fixed rate at the outset.  Save yourself the wrinkles.

6. Make sure you qualify for the mortgage amount you want at the “stress test” rate.

Talk to your mortgage broker about this one.  You might qualify for more money if you take a variable rate mortgage.  The Canadian government has ruled that *most* mortgage lenders must use the stress test rate to see if you qualify for the mortgage.  If you’re putting down less than 20%, the stress test is the Bank of Canada benchmark rate.  If your down payment is more than 20%, the stress test is either your actual mortgage rate plus 2%, or the Bank of Canada benchmark rate, whichever is higher. At times, fixed rates plus 2% are higher than the benchmark, while variable rates are lower, and vice versa. This means that getting one or the other might work to get you more money.

7.  What about exceptions to the stress test rule?

As if that’s not complicated enough, at this point in time, some lenders are still allowed to use the “contract” or actual mortgage rate instead of being forced to stress test your mortgage.  This can mean you qualify for a lot more mortgage money. The catch is a modestly higher mortgage rate compared to stress tested rates. That might be worth it if it helps you get the home you want.

Have a mortgage pro review the options with you

I can help you navigate these complicated mortgage waters.  And at the end of the day, whichever option you choose, don’t despair. At renewal time, you should be able to choose whatever you want.

Any questions – please don’t hesitate to get in touch!

For more info on this topic, check out my post, Understanding Mortgage Rates.

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