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Fixed vs. variable is a topic that I discuss with the vast majority of my clients, and now more than ever it is important to understand the pros and cons, and implications of the age-old debate. The economic policy changes and external influences that we have experienced in Canada since the beginning of the COVID pandemic have created a relatively volatile environment for borrowers, especially as we enter a period of quantitative tightening.

How do you decide what mortgage type fits the best with your goals for yourself and your property? How do you make sure that the policies in the fixed rate or variable rate mortgage that you are choosing between, including the payment amount and fluctuation, term length, and breakage penalties suit your needs and goals? In this article I will outline how to be best informed by understanding the difference between fixed and variable mortgages, and which strategy is the right choice to compliment your overall financial health.

What Is A Fixed-Rate Mortgage?

A mortgage with a fixed rate is a loan that has a rate of interest that does not change over the term period. Fixed-rate mortgages are most commonly arranged on a 5 year term, but are available from most lenders with 1 - 10 year options. The interest rate on a fixed-rate mortgage is outlined on the commitment letter from the lender and, along with the principal amount, term and amortization, will determine your payment amount. This payment does not fluctuate over the term of the mortgage.

What Is A Variable-Rate Mortgage?

A variable-rate mortgage has an interest rate that may change over the term of the loan. The variable rate is based on the Bank of Canada's prime rate, and therefore the interest rate may fluctuate with any changes in that prime rate. A variable rate is quoted as a discount or premium to prime rate. For example, you may see a variable rate presented as "p-1.00%" - this means your effective rate is determined by prime rate minus 1.00%. Seeing as today's prime rate is 4.70%, your effective rate will be 3.70%. If the prime rate was to increase or decrease, so will your effective rate.

Pros & Cons Of A Fixed-Rate Mortgage

There are advantages and disadvantages to both fixed and variable-rate mortgages, and knowing the details of the pros and cons will help to guide you when it comes to choosing one or the other. Fixed vs. variable is a decision that every borrower has to make, and being informed about how the differences could affect you is paramount.

Pros Of A Fixed-Rate Mortgage

The advantages of a fixed-rate mortgage is what you see at face value. The interest rate and payment amount does not change over the course of the term, and that brings a lot of value to certain borrowers. Knowing that the payment is not going to change if rates go up can help with planning from a monthly cash flow perspective, and can provide a general peace of mind to more conservative borrowers.

Cons Of A Fixed-Rate Mortgage

Fixed-rate mortgages are usually priced higher than current variable rates because the lender has to hedge their bets against any potential increases in prime rate so that they are not losing interest revenue should rates start to rise. In the current economic climate, we are expecting further increases over the short term which is why 5 year fixed rates are between 4.75% and 5.50% at the moment.

One of the downsides to a fixed-rate mortgage is the pre-payment penalty. It's very important to know what that penalty is before signing the commitment letter. Fixed-rate mortgages have a larger penalty to break the term early. That could mean when selling your property, refinancing to take out equity, or moving to a different lender to take advantage of a lower rate you may incur penalties that might make these moves no longer viable. The calculation used to determine the penalty on a fixed-rate mortgage is called Interest Rate Differential (IRD) and is basically a way for the lender to determine how much interest revenue they are losing based on their current rates for a term similar to the amount of time remaining in your mortgage term.

One more thing to note here is that the "big banks" will base their IRD calculations on their posted rates, which are always higher than their discount rates. Mono-line lenders (which are institutions that compete directly with the big banks for mortgages, available to consumers through independent mortgage brokers) often have better rates, policies and service and do not use posted rates for IRD calculations. Therefore they are much more favourable for borrowers looking for a fixed-rate mortgage. In summary, a fixed-rate mortgage with a "big bank" can mean big penalties if you need to break the mortgage mid-term.

Pros & Cons Of A Variable-Rate Mortgage

Variable-rate mortgages also have their upsides and downsides, but in many cases can be the right solution for less conservative borrowers. Variable rates can not only help with affordability, but also the flexibility that comes along with a lower penalty to break the mortgage before the end of the term.

Pros Of A Variable-Rate Mortgage

One of the advantages of a variable-rate mortgage is that your effective interest rate is going to be less than the fixed-rate mortgages being offered by the same lender for a similar term. This means that your variable rate payment is going to be less, at least at the beginning of the term, than your fixed rate payment. This means that, as long as prime rate doesn't increase too much, your payment will stay lower than fixed rates and you will be saving on interest costs over the term of the variable mortgage.

The second advantage to note about variable rate mortgages which often gets overlooked is the penalty to break your mortgage. All variable mortgage breakage penalties are based on 3 months interest payments, which is almost always going to be lower than the IRD calculations for the fixed rate mortgage penalty.

This affords variable-rate mortgage holders some flexibility when it comes to opportunities to sell, refinance or switch lenders for a better rate within the term of the mortgage by only incurring minimal penalties.

Cons Of A Variable-Rate Mortgage

Of course, as discussed above, there is an aspect of unpredictability that comes along with a variable rate mortgage, especially if you opt for one with an adjustable payment. Staying informed about the state of the economy, projections on interest rates by the Bank of Canada and the like will help to set your expectations about the material risks of variable mortgage rates.

From this perspective, your monthly cash-flow can be more of a concern if you are borrowing at your maximum capacity and don't have the income or savings to be able to weather the storm should your variable rate increase. If this is the case for you, then looking into a fixed payment variable rate mortgage should be a consideration.

Fixed Payment Variable-Rate Mortgages

This option is offered by some lenders, and can be a great way to take advantage of a variable mortgage rate without the risk of your payments increasing over the course of the term. Variable-rate mortgages with a fixed payment allow the portion of your payment that goes towards interest to increase, and the portion that goes towards principal to decrease, while the overall payment amount stays the same.

This may seem like a great work-around for rate-sensitive and cash-flow-sensitive borrowers, but there are drawbacks. When interest rates rise, you are paying more interest with every payment even though it may not seem like it when the payment leaves your account. Additionally, because the principal contribution of each payment is reduced as the interest portion increases, you are paying down less principal which can leave you with a surprisingly high balance at the end of the term.

With a fixed payment variable mortgage you also run the risk of what is called "negative amortization". This occurs when interest rates increase to the point that your entire payment is going towards interest and nothing is being contributed to principal at all. Different lenders have different policies for how they address this situation, but generally your mortgage payment will have to increase should you enter a negative amortization so that some contribution is being made to the principal with every payment.

How To Choose Between A Fixed-Rate Mortgage And A Variable-Rate Mortgage

When deciding between a fixed- or variable-rate mortgage there are many factors to consider, but above all it is most important to be informed about the implications of the different policies and terms associated with both. Working with a knowledgeable and experienced mortgage broker is a great way to obtain valuable advice and evaluate all options.

Disclosure of all material risks is a big part of my job as a mortgage broker, and helping my clients become informed enough to be confident in their decision is my goal. As a borrower your rate-sensitivity, cash-flow, risk tolerance, and timeline for the goals you have for your property will all inform which type of mortgage is the best choice for you. Based on these characteristics, I can make a few recommendations for 2022 and beyond:

The Economic Outlook

There is no cookie-cutter option for the best mortgage term or rate type solely based on the economic climate, especially these days when we are in a period of fluctuation in the market and in the economy. Rates are likely to continue to rise over the next 12 months (into mid-2023), but how aggressive the Bank of Canada will continue to be will depend on how the most recent interest rate hikes will affect inflation for the rest of 2022. The Bank of Canada's increase in the prime interest rate is an effort to combat rising inflation, though the reasonability and efficacy of this strategy can be debated as the inflation we are seeing now is in large part due to factors outside of Canada's economic control - such as rising food and energy costs caused by conflict in Eastern Europe, and supply chain stagnation as a result of COVID-related shutdowns in parts of China.

Because of these external factors - whose negative affects have no discernable timeline for rectification - it is very difficult to make a prediction about how many increases we will see, how high they will go, and how long they will stay there. Some experts are saying that if our central bank continues with this aggressive pattern of interest rate increases, and cost of vital consumer goods like food and energy continue to increase as well, it won't be long before we see a recession. If this happens, interest rates will drop again to early-COVID levels as the Bank of Canada will then need to stimulate the economy into repair in a similar way to what we saw two-plus  years ago.

It is possible, should supply chains get back on track and the Ukrainian/Russian conflict be resolved in the near term, that inflation could return to normal levels and we can avoid a recession. In that case, we should see a slowing of prime rate increases by our central bank and an eventual evening out of mortgage rates more in line with our country's more recent term averages.

The Best Option for 2022

First, you need to consider if 2022 is the right year for you to buy a home. Marco Pedri, a real estate broker servicing Mississauga and the Greater Toronto Area discusses whether 2022 is the ideal time to buy a house.

All of this considered, here are my best recommendations for 2022:

If you are a borrower who would sleep better at night knowing that your mortgage payment will not change and you will always be making a consistent contribution to principal, then I would not steer you away from the peace of mind of a fixed-rate mortgage. I would recommend looking at a 1 or 2 year term instead of the standard 5 year fixed because, if we do see a recession in the next short while and rates come back down, you would be stuck in a 4.75% to 5.50% interest rate with significant breakage penalties. Choosing a shorter term fixed-rate mortgage allows you to have a renewal date at a time when we may see lower rates than today. This would also prevent you from being tied into a longer term and puts you in a position to take advantage of any changes to borrowing rates in the shorter term.

If you have a higher risk tolerance and the income or savings to be able to cope with an increase to your mortgage liability every month, then I would recommend a variable rate. Even though there are further rate increases forecasted for the near-term, there is still a likelihood that a borrower will save money over a five year term based on today's fixed and variable rates. This, combined with the low breakage penalties, leads me to lean in favour of a variable mortgage for a lot of my clients.

Most lenders offer the option to lock into a fixed rate at any point in a variable term as well, although you are limited to what that specific lender is offering on the fixed side at the time of switching over.

Lastly, if you would characterize yourself as a borrower who is rate-sensitive and cash-flow concerned, but does not prioritize an aggressive pay down strategy for your mortgage, consider the fixed payment variable mortgage. Just know that you may not be paying down the principal very quickly should rates continue to rise, and your balance owing on maturity may be higher than expected.

There is one more strategy to mention that is worth considering if you have the income to support it. Most lenders offer a pre-payment policy that allows you to increase your payment amount by a certain margin in order to make a larger contribution to your principal on a frequent basis. If it is a viable option, you can look at what you would have to pay on a monthly basis with a current fixed rate, and increase your variable payment to match that. This might be an increase of $200 or $300 per month, and this way you have a fixed payment at that higher amount - like you signed on to a fixed mortgage - but your interest costs are that of a variable rate. When interest rates go up, you will not see a change because you are already paying a higher amount, the difference of which is going directly to principal.

With this strategy, should variable rates reach the same level as what fixed rates were at the time that you started your mortgage term, you are already mentally accustomed to paying that amount, plus you have been paying down your principal more aggressively until that point.

In summary, there is no one lending solution that is best for everyone based on the lending climate of today, but with multiple recommendations that can be made based on the needs and disposition of the borrower the ultimate goal of having flexibility and overall financial health should be the main considerations when making the final call.