On the surface, a mortgage is a simple concept – when a purchaser buys a home, they borrow the difference between the purchase price and their down payment at an interest rate provided by their lender. Every few years (five, for most people), the mortgage’s “term” expires and it comes up for renewal. The mortgage also has a set amortization, or the total life of the mortgage, which is 25 years for the vast majority in Canada.
But there’s a lot more to picking a mortgage, including the biggest question of all: whether to take a fixed or a variable rate. Let’s delve into the key differences between both.
Fixed rates offer “set it and forget it” payments – for a time
Fixed-rate mortgages have obvious appeal: the borrower selects a term (most people choose five years) during which their mortgage payments stay constant. That predictability makes fixed rates by far the most popular option: according to the 2020 Annual State of the Housing Market in Canada, published by Mortgage Professionals Canada, 72% of mortgage holders had fixed-rate mortgages, compared to 22% with variable rates. Another 5% had combined mortgages, which are a blend of the two.
The trade-off? Fixed-rate borrowers generally pay higher interest rates than those with a variable rate. Right now, for example, the difference in rates between fixed and variable mortgages is particularly wide, with five year fixed closed mortgage rates available from BlueShore Financial at close to 3% and five year variable closed mortgage rates around 2.60% (prime +0.15%). Note that rate ranges are as of the end of February 2022 and are subject to change without notice at any time – view our website for current information on fixed rates and variable rates.
Fixed mortgage rates are tied to the yield on five-year Canadian government bonds, and lately, these yields have been moving up as investors sell longer-dated bonds and shift to shorter-dated ones in anticipation of the Bank of Canada raising interest rates. (Bond yields move in opposition to bond prices, and longer-term bonds have less appeal in a rising-rate environment because newer bonds will pay higher interest rates.)
In the past few months, five-year government bond yields have moved up sharply, from 1.29% at the end of December to 1.81% as of February 15, 2022, increasing offered rates on new fixed-rate mortgages in tandem.
There are other things to consider here, as well. For example, if a buyer doesn’t feel they’ll own the home for the long term, the standard five-year fixed rate mortgage may not be the best choice, because the cost of ending these mortgages before the term ends can be higher than the variable-rate alternative. In that case, a shorter-term fixed-rate or a variable-rate mortgage may be a better choice; the latter of which tends to have more liberal prepayment stipulations, as discussed in more detail below.
Finally, it’s important to bear in mind that fixed-rate borrowers don’t entirely escape interest-rate risk. When the mortgage’s term ends, it will need to be renewed at the rate the lender offers at that time, which may be different than when the mortgage was first originated.
Of course, no one knows the future, but there’s a strong chance that borrowers who bought in the last couple of years, when bond yields (and fixed rates) plummeted due to the COVID-19 pandemic, will be paying higher rates when they renew in two or three years. And in light of today’s larger mortgage balances, even small changes in rates can make a substantial difference in monthly payments. This is something today’s buyers should plan for well before their renewal date comes up.
To illustrate that, here’s a quick scenario. Let’s say a homebuyer whom we’ll call Frank bought a home in Vancouver late last year and took out the average Vancouver mortgage, which, according to figures from the Canada Mortgage and Housing Corporation (CMHC), was $580,795 as of the third quarter of 2021.
Frank’s payment would come out to $2,748 a month for a five-year fixed-rate mortgage with a 25-year amortization and a 3.0% interest rate, which was available on such a mortgage at the time. Now let’s say that rates were to go up 1.75%, to 4.15%, upon renewal, which is still low on a historical basis. That would push Frank’s monthly payment up $290, to $3,038 a month, or $3,480 more a year after renewal.
Variable rates: Less predictability, but potentially bigger savings
As the name says, the interest on variable-rate mortgage payments changes with interest rates, but unlike fixed rates, variable rates aren’t tied to bond yields: instead, they move in lockstep with the Bank of Canada’s policy rate.
And unlike bond yields, the policy rate remains fixed unless adjusted by the Bank of Canada when it releases its rate announcements every six weeks. In rare circumstances, the bank will make a move between scheduled rate announcements, such as when the coronavirus hit Canada, prompting it to make a 50-basis-point cut on March 13, 2020, and another 25-basis-point cut on March 27, 2020. (One full percent equals 100 basis points.)
There are two main types of variable-rate mortgages: those where the payments rise and fall in lockstep with the Bank of Canada’s policy rate and those, like the BlueShore variable-rate closed mortgage, where the payment stays the same, but more of it goes to interest or principal as the central bank’s policy rate moves up and down.
Borrowers still select a term (these range from six months to five years with BlueShore’s closed variable-rate mortgage, for example – though five years is the norm), and the lender would lengthen or shorten the amortization to account for any shifts in rates. If rates rise sharply, these mortgages also contain a “trigger point” at which time the payment may rise. If that were to occur, the lender may also give the borrower the option to make a lump-sum payment to bring the balance down and keep the amortization on schedule.
To be sure, variable rates do involve more uncertainty than fixed rates, so you should only take one if that fits your comfort level. They may also be a good choice if, as mentioned, you think you may sell your house before your five-year term is up, as a variable-rate mortgage has low prepayment charges. Likewise, if you think you might sell your home within a short period of time, then a shorter term might work better for you.
The upside, of course, is that they tend to save borrowers money over a fixed rate during the life of the mortgage.
Finally, with most variable-rate mortgages, borrowers have the option to “lock in” to a fixed rate at any time. With the BlueShore closed variable-rate mortgage, for example, this can be done any time within or after the mortgage’s first year (with the mortgage converting to a three year or longer fixed term). A common misconception is that when a borrower locks in, they simply hold at the interest rate they’re currently paying. That’s not the case; speak to your BlueShore Financial advisor for specifics regarding your mortgage.
Wide gap between fixed and variable rates could affect borrowers’ decisions
One other thing to consider is that, as mentioned earlier, the spread between today’s variable-rate mortgages and fixed rates is historically wide. So even though rates are likely to rise in the near term, they would have to rise by several quarter-point increments (the size of the typical Bank of Canada rate hike) to cover a gap of that size. Depending on your outlook for interest rates and, again, your tolerance for uncertainty, a variable rate could make sense for you.
Let our expert mortgage specialists help
As you make your way through the mortgage process, you can be certain our experienced BlueShore Financial advisors will be there for you every step of the way. Plus they’ll work with you throughout your mortgage’s amortization – including at that all-important renewal time – to make sure it continues to fit your needs.
Have a question? Ask an expert
Our team of experienced professionals are here to answer any questions you may have.