The variable vs fixed mortgage rate decision is one of the biggest a borrower will make when selecting their mortgage.
It’s a decision that will affect a homeowner for years to come and could be the difference in literally thousands of dollars of the interest cost.
In 2021 as the effects of coronavirus sweep through the Canadian economy, we will see that, even though fixed rates are now at all-time lows and are a fantastic solution for many, the answer for most people, is still variable.
If this is all you need to make a quick and decisive decision, then great. You should do well with this advice. However for those who would like to see the compelling reasons why, at this specific point in history, the variable rate makes more sense than fixed for most people, then I invite you to read on.
Variable or fixed mortgage in 2021? Which is right for you?
To help determine this, we will look at:
- The difference between variable vs fixed mortgage rates.
- 5 Reasons why a variable rate should lead to more savings now, and for years to come, including:
- Historical, long term evidence of variable rate cost savings.
- Effects of COVID and Why the variable rate should not increase any time soon.
- How to minimize the risk associated with a variable rate mortgage. (special 2021 update)
- How variable rates offer more flexibility and lower penalties than fixed rates. (special 2021 update)
- How to effortlessly determine when to switch into a fixed rate.
- Why a fixed rate mortgage will still be the best path for many.
Variable vs Fixed Mortgage Rates: Features Compared
The short video just below will simplify the variable vs fixed mortgage rate differences and provide a good basis for our discussion.
- Locks your rate into place for a period of time called the term (usually 5 years).
- Rate is typically a bit higher, but provides for a stable, consistent mortgage payment for years to come.
- If you break the mortgage, there is often a bigger penalty called an Interest Rate Differential Penalty.
- It is not possible to switch a fixed rate into a variable rate without breaking the mortgage.
- The rate floats or changes over time, with decisions from the Bank of Canada.
- The rate is determined using a discount off of the Prime Rate (ex. Prime minus .50%).
- Typically, the variable rate is lower than fixed, but can also float higher for periods.
- If you break the mortgage, the penalty is typically far lower.
- You can lock the variable rate into a fixed rate at any time, without breaking the mortgage.
Variable Mortgage vs Fixed: 5 Reasons Why Variable is Better in 2021
Variable is Historically and Statistically Shown to Cost Less than Fixed
According to a 2001 report completed by Moshe Milevsky, Professor of Finance at York University Schulich School of Business, variable mortgage rates beat 5 year fixed rates 70% – 90% of the time.
Using data from 1950 – 2000 the study includes a period of high market volatility in the 1980s and 1990s where mortgage rates were much higher than they are at present. This means that the data used in this study is not selected during a period that would manipulate the results to favour a variable rate over a fixed rate.
In fact, I believe it’s quite the opposite. I believe that the rate volatility in the 1980s and 1990s skews the argument more towards fixed rate and that it is more likely for rates to remain far lower for at least the next decade.
With this said, in the author’s words “When interest rates are at low levels, one is better off locking in at long term rates”.
In other words, the author of the study suggests that variable rates are the better choice, but locking into a fixed-rate mortgage at the right time is ultimately the goal. This is exactly what our article here will go on to explain in more detail.
On a side note, some will point to the period of higher interest rates during the 1980s and 1990s as a reason to avoid a fixed rate. However, as we will review below, we live in a very different, debt-laden economy now whereby the effects of a 1% higher Central Bank rate can have 5 – 10 times the economic impact as a 1% higher rate did in the 1980s.
Therefore, I contend that unless we see substantial economic GDP growth and inflation, we are not likely to see the kind of high rates that were seen in the 1980s and 1990s.
Variable Mortgage Rates Canada Prediction: Effects of COVID (and Why the variable rate won’t increase any time soon).
As the effects of COVID, unfortunately, continue to take their toll on the broader Canadian and global economy, it is likely that, as of 2021, it will take several years for the economy to stabilize and then begin to grow again.
The economy indeed can be thought of like a giant ship that can take a while to turn around.
One of the biggest mechanisms that the government has to stimulate an economy is its control over interest rates through the Central Bank of Canada.
If interest rates are lowered – and kept low – this lowers costs of borrowing which does two main things:
- It reduces what borrowers need to spend on interest, so borrowers have more money to spend on other things in the economy.
- It makes borrowing more attractive, so people borrow more, and spend more with this borrowed money – and this boosts the economy.
So my main variable mortgage rate prediction here is that the Government of Canada will want to keep interest rates low for a long period of time because the economy needs a lot of stimulation given the effects of coronavirus. The Central Bank of Canada will not likely start to increase rates until the economy begins to grow at a stable pace, which is still likely 2-3 years down the road.
From another perspective, it would appear that the Central Bank of Canada literally can’t increase rates too soon because this would send the economy into a depression.
When the economy does eventually start growing, the Central Bank of Canada will need to be careful how quickly they increase rates, and by how much – because our economy simply can’t handle too much rate increase too soon.
Variable-rate mortgage holders stand to benefit most from this low rate interest environment over the next 2-3 years.
Fixed or Variable Mortgage: How to Minimize the Risk Associated with a Variable Mortgage
Here we revisit the fundamental question of why we are even taking the time to a fixed or variable mortgage. The answer for most is to save more money on their mortgage, in one way or another.
The strategy here will show you how to lower your risk on a variable mortgage while also setting you up to save substantially on interest over time.
I call this more specifically, ‘variable rate risk mitigation’ and it involves using the extra payment/ prepayment privileges found in the mortgage fine print terms to increase your variable mortgage payment to the same payment that you would be making at a higher rate 5 year fixed rate mortgage.
5 Year Rate 2.49%
25 YR Amortization
Variable Rate 2.00%
25 YR Amortization
Then using prepayments, boost the variable payment by $72 per month to $1,342 – the same payment as you would have been making on the fixed rate.
Variable vs fixed rate mortgage: Pre Payment Result
By increasing the payment on the variable rate to be on par with the fixed rate, we are taking advantage of the variable vs fixed rate mortgage to pay down the mortgage faster.
This helps to reduce risk because as we spend time getting ahead on payments near the beginning of the mortgage, it buys us time later on in the term when rates are more likely to increase.
Even if variable rates surpass, or go higher than the fixed rate comparison, it would still take some time – perhaps years – for you, the borrower, to actually end up paying more for the variable rate mortgage vs fixed rate mortgage option.
Variable rate mortgage vs fixed rate mortgage: Not if but when rates increase
Also, not if, but when variable rates eventually start increasing again, and your paying increases as a result of the variable rate increase, you could simply remove the additional pre payment that you were making at the beginning of your mortgage to help keep your payment more consistent over time.
So even though you would not be hammering away and getting ahead as quickly as you were, you would have already made substantial progress on your mortgage, and you could have the peace of mind of a built-in mechanism to keep your mortgage payment more consistent.
A good mortgage broker can easily work with you to implement this kind of risk mitigation strategy with the lowest rate variable mortgage.
Variable mortgage vs fixed: How variable offers more flexibility and lower penalties than fixed
Closely related to lowering risk as seen in the last point, the lower penalties and increased flexibility built into a variable rate mortgage are a cornerstone of a variable rate.
When looking at a variable vs fixed mortgage, it should be taken into account that, especially during the first 3 years of a fixed rate mortgage, the penalty to break the mortgage can be extremely high.
As a mortgage broker for over 11 years, I have seen many individuals faced with massive ‘interest rate differential penalties’, when breaking their mortgage for any number of reasons:
- Refinancing to pull out equity
- Switching into a lower rate
- Family changes
- Many more…
This trend was especially the case in 2020 as many who are in a fixed-rate mortgage in the mid to high 2% range were faced with cost-prohibitive penalties in the $10,000’s to break their higher-rate mortgage. This was not the case for those in a variable rate mortgage, and this kind of flexibility could certainly come into play in 2022-2023 as rates may threaten to increae.
While a discussion of penalty details is beyond the scope of this article, the point is that most variable rate mortgages (the ones without terrible fine print) will only ever charge 3 months interest penalty if you end up breaking the mortgage. The 3 month interest penalty is far lower – often to the tune of thousands of dollars lower than comparable fixed rate mortgage penalties.
Five years, the typical mortgage term, is a long time, and it can be difficult to tell exactly the way things will play out further down the road. So an important financial planning strategy is to remain flexible and agile to help accommodate changes.
The variable rate mortgage is, in many cases, the right financial tool to help accommodate these changes.
I also contend that the lower penalty of a variable rate, offsets much of the risk associated with a fixed vs variable mortgage.
Timing a Fixed Rate Lock-In
The points mentioned so far mainly apply to the period where you are in a variable rate.
While many will choose to remain in a variable rate for the entire term, one of the fundamentals of a variable rate is the ability to lock into a fixed rate and I believe that there will be a best time to make this transition.
For example, if interest rates remain at ultra-low levels for the next two years, and then threaten to increase – at this point it would be a good time to switch to a fixed rate. Why?
Because by timing the market you prolong the time spent in an ultra low rate mortaage. On the other hand, if you lock into a 5 year fixed rate now, then once 5 years is up rates are likely to be significantly higher. However, if you wait until rates are ready to go up then you may have provided yourself with another year or two of ultra-low rates.
During an Economic Crisis Rates are Inflated
The first important thing to understand when timing a fixed rate lock in, is that during an economic crisis, mortgage lenders and Banks price fixed rates higher.
More specifically, there is a ‘loss provision’ premium built into fixed rates during times of economic instability and uncertainty.
We saw this risk premium applied to fixed rates during the 2008-2009 US mortgage crisis that affected Canadian markets. We are also seeing this risk premium added in 2020-2021, due to the uncertainty and market risk brought on by covid.
I estimate that this risk premium is currently causing fixed rates to be anywhere from 0.25% – 0.50% higher than they would be under normal economic circumstances. So even though, at the time of writing, 5 year fixed rates are in the 1.39% – 2.00% range, without the loss provision/ risk premium that lenders have added, rates would be approximately 0.25% – 0.50% lower for 5 year fixed rates.
Learning From Mortgage Rate History
In looking at past market behaviour, what happens is, when the economy stabilizes and banks and mortgage lenders become more confident in the short and long term economic outlook, then they begin to reduce their risk related rate premiums.
When this happens, we see fixed rates drop across the market.
So, for a period of time, we have two forces working together
- Low rates to help stimulate the economy (since we’re not yet out of the woods)
- A stabilizing economy that lenders feel more comfortable with.
Although it is impossible to perfectly time any market, we can look at these trends together to help determine a ‘low point’ in the market cycle, as Moshe Milevsky put it in his fixed vs variable rate mortgage study.
To summarize, I believe that fixed rates over the next 1-2 years will generally trend down as the economy stabilizes after coronavirus and that this trend will present us with an ideal time to lock into a fixed rate.
With this said, many people will not want to follow the market themselves to time such a fixed rate lock-in. At Altrua, with our deep knowledge of the economic factors that affect/change mortgage rates, one of our specialties is helping our customers to determine when to lock in a rate. We stay in touch, so they don’t have to do any extra legwork after their mortgage closes.
Implementing the Variable rate strategy and How to determine when to switch into a fixed rate
There are three key things to consider when choosing a variable rate mortgage:
- The Upfront Rate
- The Fine Print
- The Mortgage Advisor
The Upfront Rate
Selecting the best variable rate will help you save thousands of dollars.
While one bank may offer a 0.20% discount off of the prime rate, another may offer a 0.40%, resulting in a lower variable rate and guaranteed savings over time.
Selecting a good mortgage broker will help you get the best rate with ease.
The Fine Print
While there are several features of the mortgage fine print to consider in general, there are three points that need to be considered more seriously for a variable rate mortgage.
Fixed Rate Lock-in Features
Some lenders will offer a very high fixed rate if you decide to use the lock-in feature. Select a lender with a good fixed rate discount to make locking into a fixed rate much more cost-effective.
Most variable mortgages use a 3 month interest penalty if you break the mortgage. However, some lenders with the absolute lowest rates will charge a 3% penalty to leave the variable rate. This is a major difference in penalty and a higher penalty adds to the risk of the variable strategy.
Selecting a Long term Mortgage Advisor
For many, the key to implementing the best variable rate strategy will be selecting a good mortgage partner. This partner should possess:
- A strong knowledge of the economics behind mortgage rates.
- A system in place to help communicate ongoing rate advice in a timely manner, so you don’t need to constantly watch rates.
- Access to the leading mortgage lenders with the best variable rates.
Like a good investment advisor will help to tweak or optimize an investment portfolio over time, to manage risk and achieve a higher return, similarly a good mortgage advisor.
Why a fixed rate mortgage will still be the best path for many.
There’s nothing that will ruin one’s credibility like being 100% one sided for one idea or another, and this can’t be more true when looking at the variable vs fixed mortgage discussion.
I believe that the variable strategy described above is best for many, but not all mortgage holders.
There is one golden aspect of a fixed mortgage rate that is hard to put a price on: peace of mind.
How does one measure peace of mind? It’s nearly impossible to measure and the value of it can be near infinite.
Fixed rate mortgages are designed to provide peace of mind, and with rates at such low levels as they are at in 2021, how could you really go wrong by keeping things simple.
‘Set it and Forget it’
I have attempted to show why and how a borrower is likely to save money with a variable rate-fixed rate timed strategy, however what’s the point in saving money if you’re constantly stressed out about it.
There are no guarantees out there, only past experience and likelihoods.
So, for those of you that have made it here to the end, perhaps the real conclusion of the fixed or variable mortgage conversation should instead be: Fixed and variable are both the best decision – depending on who you are.