When you’re looking to buy a home or renew your mortgage, one of the most important decisions you’ll have to make is whether to sign up for a fixed vs. variable mortgage. Many people prefer a fixed rate mortgage because of its stability; you know exactly how much you need to pay every month and how much of your principal you’ll pay down, no matter what happens to the Bank of Canada’s key interest rate (also known as its overnight or policy rate).
The counter-argument is that variable mortgages have the potential to save you a lot of money in the long run. Variable mortgages have historically offered lower rates than fixed mortgages (though that has changed in recent years), and you’ll pay less in interest pretty much every time the Bank of Canada cuts its key interest rate.
While people with variable rate mortgages can certainly benefit during periods when rates are falling, they can also struggle when rates rise suddenly. During 2022, for instance, the Bank of Canada’s key interest rate rose from 0.25% to 4.25%. Anyone with a variable rate mortgage that year could have found that either their mortgage payments dramatically increased or the amount of principal they were paying off slashed, possibly increasing their amortization period.
To help you decide between a fixed versus variable mortgage, let’s take a look at the differences between them and how they work. What are the pros and cons of both of them? And — most importantly — is a fixed or variable-rate mortgage best for you?
What is a fixed mortgage and how does it work?
Regardless of whether you take out a variable or fixed mortgage, you’ll have to pay interest on the money you borrow. With a fixed-rate mortgage, you’ll sign up for a specific interest rate and will pay that rate for the entire length of your contract term (which is typically between one and five years, with five-year terms being the most popular).
Therefore, a key difference is that with a fixed mortgage you’ll always know what your interest rate will be; your mortgage payments will not change and you’ll pay consistent amounts off your mortgage principal (the outstanding amount you owe on your mortgage), for the duration of your mortgage term.
The rates being offered on fixed mortgages are, on the whole, based on the rates of Bank of Canada bond yields (though they are a little higher than bond yields, a difference which is called a spread). If these bond yields rise, so too do fixed mortgage rates, and vice versa.
Once you’ve chosen a fixed rate mortgage, you’re stuck with it until you renew your mortgage or decide to break your mortgage (which would normally result in a large penalty).
Mortgage term vs. mortgage amortization
In Canada, a mortgage term is the length of time your mortgage contract will last. Your contract with your mortgage lender will list the terms of your conditions, including the type and amount of interest charged, prepayment privileges, etc. Mortgage terms typically last for five years or less.
Mortgage amortization is the amount of time it will take to pay off your entire mortgage, based on the current outstanding amount owed and your interest rate. Amortization periods usually start out at 25 (or sometimes 30) years for first-time homebuyers and then reduce as the money owed is paid off.
What is a variable mortgage and how does it work?
If you sign up for a variable mortgage, the interest rate will be based on your lender’s prime lending rate. This rate is in turn based on the Bank of Canada’s key interest rate. Typically, a variable mortgage interest rate is the lender’s prime lending rate minus a certain amount (for example, minus 50 basis points, or 0.5 percentage points). For example, if your mortgage was prime minus 50 basis points and the prime rate was 5%, you would pay 4.5% interest.
As the name implies, however, there could be a variation in the rate you pay over the mortgage term. Lenders’ prime rates typically rise and fall along with the Bank of Canada’s key rate. So, continuing with our example, if, six months later, the Bank of Canada reduced its rate by 50 basis points (0.5 percentage points), your new interest rate would be 4%.
The Bank of Canada uses its key interest rate to try and manage inflation and the economy. If, for example, inflation is too high, the bank might raise interest rates to help lower inflation to its target rate (which is around 2%). If the economy is struggling, the bank might lower rates to boost spending and help grow the economy.
There are two types of variable mortgage. One has fixed mortgage payment amounts, even if the Bank of Canada rate changes; the other resets both the interest rate and the mortgage payment amount when the prime rate changes.
If you have a fixed payment variable mortgage and the prime rate goes up, you pay the same amount each month. However, the amount of that payment that goes towards interest increases, and the amount that goes towards the principal decreases. This will lengthen the amortization period of your mortgage (which means it will take longer to pay it off). Conversely, if rates drop, and more of your payment goes towards the principal, your amortization period will shorten.
If you have a variable mortgage that resets the payment, and the prime rate goes up, you’ll have to make larger monthly payments, but your amortization period will stay the same.
Unlike with a fixed mortgage, you’re not stuck with a variable rate. You can switch your variable rate over to a fixed rate at any time during your term, without paying a penalty. Find out when this might be a good idea.
Pros and cons of a fixed-rate mortgage
A key advantage of a fixed vs. variable mortgage is that you know exactly what rate you’ll be paying over the entire course of your mortgage term and by how many years you’ll be reducing your amortization period. This is really helpful for people who want more control over their budgeting or who are risk averse.
During periods of high inflation and severe interest-rate hikes, it can be both comforting and financially beneficial to have a mortgage rate that stays the same, regardless of what the Bank of Canada decides to do.
There are also several disadvantages of a fixed vs. variable mortgage. Historically, fixed rates have been higher than variable mortgages, at the time you sign up for it. While this has not been the case in recent years (with variable rates higher than fixed rates), this situation is unlikely to last long.
Fixed mortgages are less flexible than variable; you can’t switch to a variable mortgage without breaking your contract.
If you need to break your mortgage for any reason, the penalty you’ll pay is based on a calculation called the interest rate differential, which is typically thousands of dollars more than the penalty for breaking a variable rate mortgage.
Pros and cons of a variable-rate mortgage
In the past, variable mortgages have usually saved homeowners money over the term of the mortgage. Normally, the variable mortgage rate available at any one time is significantly lower than the best comparable fixed mortgage rate. This difference is often as much as 100 basis points (one percentage point) or more. Taking on a variable mortgage is riskier and so the rate is usually discounted to reflect that risk.
Many fans of variable mortgages quote research by Moshe Milevsky, a professor of finance at York University. He found that, between 1950 and 2000, Canadian homeowners would have been better off with a variable mortgage almost 90% of the time. More recently, between 2007 and 2022, the five-year variable interest rate has mostly been lower than the five-year fixed rate, sometimes considerably so. As mentioned above, however, this has not been the case since 2022.
With a variable mortgage, if the prime rate falls, you’ll either have lower mortgage payments or pay off more of your principal.
A key advantage of a variable mortgage is that, if you need to break your mortgage for any reason, the penalty is typically three months of interest, which is usually considerably less than the penalty you’d pay with a fixed mortgage.
You can also convert your variable mortgage to a fixed mortgage at any time, with no penalty.
The main disadvantage of a variable-rate mortgage is that if interest rates rise, so does your mortgage interest. As we mentioned, this can lead to either higher mortgage payments (which can derail your budget) or lower principal payments (which can extend the amortization period of your mortgage).
Fixed vs. variable mortgage: which is better for you?
This is very much a loaded question, in that it suggests that one or the other might be better for everyone. The best option will depend on your own unique situation, your risk tolerance level and the type of mortgage that fits best into your financial plan.
The answer will also depend on where rates stand at the time you’re making your decision. For example, if variable rates are on the higher end (around 5%), fixed rates are a whole percentage point higher, and the Bank of Canada is signalling that rates might soon be on a downward trend, then a variable mortgage could be a wise option.
Alternatively, if variable rates are considerably higher than fixed rates (as they have been recently) and the Bank of Canada’s rate is unlikely to fall any time soon, then a variable mortgage may not be the best choice.
More importantly, any mortgage should be considered within the context of your financial plan and far beyond simply fixed vs. variable. This includes the size of the mortgage, the rate, the term, the amortization period, monthly payments, prepayment privileges (how much of your principal you can pay off early), prepayment penalties and portability (the ability to take it with you if you buy a new home).
Mortgages shouldn’t be viewed in isolation; having a financial plan that integrates your mortgage can be a huge advantage. After all, it tends to be your biggest debt. It can help you improve your cash flow, reduce your high-interest debt, increase your retirement savings and even pay off your mortgage faster.
Talk to your IG Advisor to discuss which is the most suitable mortgage for you and how to best integrate it into your financial plan. If you don’t have an IG Advisor, you can find one here.
Written and published by IG Wealth Management as a general source of information only. Not intended as a solicitation to buy or sell specific investments, or to provide tax, legal or investment advice. Seek advice on your specific circumstances from an IG Wealth Management Advisor.
Mortgages are offered by Investors Group Trust Co. Ltd., a federally regulated trust company, and brokered by nesto Inc. Licences: Mortgage Brokerage Ontario #13044, Saskatchewan #316917, New Brunswick #180045101, Nova Scotia #202507230; Mortgage Brokerage Firm Quebec #605058; British Columbia, Alberta, Manitoba, Newfoundland/Labrador, PEI, Yukon, Nunavut, Northwest Territories.
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