Variable vs. Fixed Mortgage Rates: Weighing the Pros and Cons

As the bank of Canada continues to raise interest rates in efforts to return inflation to its target rate of 2% (we are currently trending around 7%) it has left many concerned variable rate mortgage holders wondering, if it's finally time to consider a fixed rate strategy. However, the peace of mind that comes with a steady rate also has its trade off’s. As with all things, there are pros and cons that homeowners should be aware of before making the switch.

Adjustments for Variable Rate Holders

For the first time in over a decade variable rate holders are experiencing adjustments to their mortgage payments as a result of the Bank of Canada raising the overnight lending rate. Although the Bank of Canada does not set mortgage rates, it does have an impact on the rate you receive from the financial institutions you borrow from. Variable rate mortgage holders with adjustable payments are seeing their monthly mortgage cost rise in step with the central banks rate hikes – and it hasn’t been very comfortable for most.

Remember, the whole purpose of Federal Government managing monetary policy this way is to reduce the amount of money circulating in the economy to stifle demand. One might wonder “Why? … isn’t a strong economy what we want?” The answer is yes, however too strong is not healthy either and when economies are too strong, inflation can get out of hand and that can be very dangerous. Many of you experienced the impact of inflation if you were shopping for a home over the past few years. The unfortunate circumstance for many first-time homeowners who were desperate to enter into the housing market either overpaid; some to the tune of hundreds of thousands of dollars for their first home or were completely priced out altogether and decided to continue to rent until things cooled down. This is just one example of how hyperinflation can be very dangerous.

Considering Fixed Rate Mortgages

For variable rate mortgage holders, the rate hikes are seemingly unrelenting right now and many are wondering if it’s time to pull to trigger and lock in their rate to prevent further pain. Some are looking to hedge their risks by locking in a slightly higher fixed rate today in anticipation that the Bank of Canada will continue to raise rates higher than the current spread. This becomes a circumstance of trying to time the market and we simply do not know where future rates will be. We know they will eventually come down, “but when? … and what do we do right now?” are a few questions many of you are asking.

To that, we advise every situation is different, as it always is in planning there isn’t one solution that fits all. It is important to note that fixed rates have been increasing significantly as well and as those who chose a fixed rate are up for renewal, they will be faced with a big decision to make as well. When making the variable vs. fixed decision in the current rate environment, your decision should come down to two things your appetite for risk and your household finances.

Historically over the entire life of your mortgage (typically 25-30 years) variable rates outperform fixed rate mortgages and there is a high chance you will be paying a lot less over the entire mortgage term with a variable rate – this is why they are so popular.

(Source: Canada Mortgage and Housing Corporation)

Comfort and Predictability

But there are several other factors to consider when choosing which mortgage rate is best for your situation. As we explain to our clients often times it is not about where you are going to make the most money, the strategies we help our client choose to obtain their goals have a lot to do with where they feel the most comfortable. To figure out where you are most comfortable you need to be able to fully understand your options and the risks and rewards associated to both scenarios.

For some, the predictability of a monthly mortgage payment is the comfort they are looking for regardless if they may spend more on their mortgage over time. This is often why some people want to invest in GIC’s vs. the stock market. They will forgo higher potential returns for a fixed rate even if its lower than inflation just to have the peace of mind the value of their savings won’t fluctuate. So, do people pay more at times for peace of mind? Absolutely, and that’s okay. If it’s a strategy you understand, and feel completely comfortable with then it’s the appropriate strategy for you.

Anticipating Life Developments

In deciding which option is best one also needs to anticipate other major life developments over the next 5 years that might lead to a mortgage change. Like having kids and needing a bigger home, retiring and downsizing, moving cities, the need to refinance for a major renovation you plan to make and although it’s not something anyone plans for; a potential divorce or disability and losing your ability to maintain the same level of income. These are just some common examples for reasons you might need to break your current mortgage. If you anticipate any of these changes sticking with the variable rate provides much more flexibility than a fixed-rate because of the harsh penalties imposed on breaking the latter.

Penalties and Fees

Having said that variable rate mortgages all come with a penalty equal to three months interest, while their fixed counterparts can have higher fees based on how much term you have left in your mortgage tied to the differential between the contract rate and today’s interest rate. This can represent a steep hefty penalty.

In closing, it’s very normal to be fretting about the pain the higher rate environment is causing right now, we should all be weighing the pros and cons of making a potential switch and how it may or may not benefit your situation but it’s also important to remember that the rates rise and fall in cycles and lower rates will return. Locking in certainly provides peace of mind, but the downside to that might be missing out when inflation is back under control and the Bank of Canada eventually lowers rates.

Remember that the only guarantee in financial planning is that things will change, and what worked and made sense one year might no longer make sense anymore. We encourage all of our clients to give us a call and chat this through if you’re feeling anxious and are teetering on what decision what might be the best for you.