Fixed vs Variable Rate Mortgages: Understanding the Differences

Whether securing a mortgage for your first home or considering refinancing a property you have already purchased, an important decision of choosing a fixed or a variable rate mortgage needs to be made. There is no definitive answer to this question, as the choice depends on the individual's circumstances. Today, we will share some additional knowledge to help you make a decision, taking into account the current status and overall uncertainty regarding the market conditions in 2022. 

Taking out a Mortgage

Firstly, let’s understand what we’re talking about when we discuss fixed vs variable rates. A mortgage is an agreement between you and a lender to take out a large sum of money to finance the purchase of a real estate property. In return, you agree to repay that loan over a period of time. 

Because money today is worth more than money tomorrow (especially in a period of high-interest rates!), when you pay the money back every month, part of your payment goes towards the principal (paying off the initial loan), and part goes to the interest (additional money the lender charges to compensate for the loan). When you pay off the principal, you gain equity in the property, which can be used to secure additional favourable loans and increases your overall net worth. For the consumer, the key is to pay off the principal as quickly as possible while minimizing your interest payments. 

What Affects Interest Rates

Let’s go deeper into the interest rate components. The interest rates are partly guided by economic decisions made by the federal government and the Central Bank of Canada. They are affected by elements such as the “prime rate” and the 5-year bond rate. Considering this to be a simple dilemma between either fixed or variable does not provide a deep enough understanding of the multiple options at play. We will start with a high-level comparison, then discuss some additional components to consider. We will also touch on stress tests and trigger rates, finalizing our understanding of how interest rates are important in the conversation around housing in Canada. 

Components of a Fixed-Rate Mortgage

A fixed mortgage rate establishes your monthly payment upfront for the entire contract term. Because the interest rate is fixed, your payment amounts are also fixed. This provides predictability and security, which is offset by a typically higher interest rate than the variable mortgage option. Within fixed mortgages, the two key different types are open or closed. Open mortgages allow you to make prepayments, pay off the principal, or switch to a new term at any time without penalties. Closed mortgages mean that your payments stay the same throughout the term, with little flexibility to make lump-sum payments.

Fixed rates are attractive when the overall interest rates are low, as you can lock in favourable rates that may change significantly during a recessionary period. Consider the past couple of years, where the central bank offered historically low rates to encourage an incredibly strong housing market. In contrast, as a potential recession looms, the Bank of Canada has raised rates multiple times, dramatically shifting the overall market and cooling consumer demand for housing and other financial products. 

Components of a Variable-Rate Mortgage

These shifts to the prime rate have already greatly impacted variable rate mortgage holders. With a variable-rate mortgage, you have two considerations. You can either get a variable interest rate mortgage with variable payments or fixed payments. With variable payments, you must be aware that your mortgage interest rate could increase, meaning your monthly payment amount would increase. As interest rates have increased, these borrowers are experiencing higher monthly payments. Depending on the timing and the changes to your rate, you may pay more in interest than you would’ve if you had chosen a fixed-rate mortgage. Again, variable rate mortgages can also be open or closed, providing variety in your ability to make additional payments to pay down the principal. 

Alternatively, you could choose the variable rate with fixed payments. This means that your mortgage's amortization period (length of time) could increase even though your monthly payments stay the same. The interest rate changes with the prime rate, and any residual pays down the principal. The variable rate is guided by the prime rate, which is directionally set by the interest rate established by the central authority - in Canada, this is the Bank of Canada. In turn, the “prime rate” is offered to the best customers of Canada’s Big 5 banks. 

Which Mortgage is Right for You?

Choosing between fixed and variable depends on how long you plan on staying in your home and your current financial situation. If you are comfortable with risk, a variable rate may be worthwhile. When discussing variable rate mortgages, two additional components are the stress test and the trigger rate. For those on the edge of affordability, the problem comes in the form of these two tools. These have become much more relevant in the national discourse in recent months, as more potential and current borrowers are experiencing changes to their borrowing situation. Let’s look at how a current or potential mortgage can be shaped by the stress test and the trigger rate.

Purpose of a Mortgage Stress Test

Lenders use the stress test to manage the sustainability of mortgages and their monthly payments and to avoid any disastrous situations where large numbers of mortgage holders fail to pay their monthly payments. The stress test is designed to assess whether any borrower can still make their mortgage payments if interest rates were to rise. Lenders will typically add a hypothetical percentage to your current mortgage to determine if you can still make your payments.

If borrowers can't afford their mortgage payments at this rate, they will likely be denied a mortgage. The lender intends to manage the mortgage holders' Debt Service Ratio by understanding what percentage of their pre-tax income goes towards their monthly debt services across all loans. This prevents situations where the mortgage holder gets in over their head and is forced to default when rates rise across multiple loans. For those on the edge of qualifying, lenders may advise a potential borrower to either pay off other debts or save up to increase their down payments to reduce their monthly mortgage payments.

Purpose of a Mortgage Trigger Rate

The trigger rate is another tool lenders use, but it is aimed instead at people who have already qualified for a variable rate mortgage. Essentially, a new rate is “triggered” that bumps up the minimum monthly payment for the mortgage holder. This occurs when the borrower's monthly payment no longer pays off any of the principal amount. Instead, they are paying purely interest. By asking for additional payments, the borrower is forced to continue paying down the principal - paying towards a loan that keeps increasing every month is individually demoralizing and dangerous to the broader economy.

According to the Bank of Canada, in terms of the practical outcomes, about half of Canadian mortgages with a variable rate hit their trigger rates in October 2022. In addition to the monthly payment increase, the lender can also choose some other alternatives. Firstly, negative amortization, where the interest rate payment exceeds the total mortgage amount. Allowing this keeps the payments low but increases the total length of the mortgage until the payment to the principal balance returns to positive. Secondly, some lenders may also reach out to the mortgage holder to offer a fixed-sum payment or an opportunity to switch to a fixed-rate mortgage. The decision to change is based on the borrower’s willingness to risk locking in a rate in light of potential future decreases or increases to the prime rate. 

So, where does that leave someone needing to decide about a mortgage? Well, the first stop for your questions should be Loyal Homes’ Client Care Coordinators. Our team of experts can help you gain clarity on your current situation, regardless if you already have a mortgage or are considering acquiring one. Whether you have general questions about some of what we discussed above or need more specific advice, this should be your first stop. Our team can connect you with our network of vetted experts if you need mortgage services, and we will guarantee that anyone we connect you with shares our commitment to 5-star customer service no matter your inquiry or requirement.