Fixed vs. Variable Rate Mortgages: Which One Is Better For You?
So let’s start with the basics first and talk about what a fixed rate mortgage and a variable rate mortgage are.
A fixed rate is linked to Government of Canada bond yields. Once you enter into a fixed rate mortgage with a lender, your rate won’t change for the duration of your term. So if you enter into a five year fixed rate mortgage, your monthly mortgage payments will be the same for five years.
Variable rates are linked to Bank of Canada’s prime rate, and it’s quoted as the prime rate plus a premium or minus a discount. So as prime rate changes over time, your variable rate will also change over time.
Now the good thing about fixed rates is that you know how exactly your monthly payments will look like, but at the same time it can also be your pain point because fixed rates are much less flexible. When interest rates drop, you’re stuck at a higher fixed mortgage rate but you can take advantage of lower rates or even transfer to another variable mortgage with a better discount at any time if you had a variable mortgage.
On the flip side when interest rates rise, variable rates continue to be flexible meaning you can still transfer into a fixed rate mortgage if you want to limit your interest rate exposure at that time.
Next, let’s see which type of mortgage actually has the lower cost. A report done by York University’s Schulich School of Business concluded that variable mortgages outperformed five-year fixed mortgages 70-90 percent of the time.
So if you want to make a decision based on historical numbers, then your cheaper option is most likely with variable mortgages. At the current moment, variable rates are in general around forty basis points cheaper than fixed rates, so right now you can expect lower monthly payments with variable mortgages. From a borrower’s standpoint this makes sense – there is a premium for fixed rate mortgages because it has a built in insurance, and you’re passing on the interest rate risk to the bank.
Now we’re in Q1 2020, still in the middle of the COVID pandemic and unfortunately this is all taking a toll in the global and Canadian economies. This weakness isn’t going to go away anytime soon. In fact, economists from the big banks all predict that interest rates will stay the same until the end of Q2 2022. And major census now expects rates to start rising in Q3 2023, which means we still have 2.5 two and a half years to go before rates start changing. Now based on this information, how would variable mortgages compared with five year fixed mortgages over a term of the next five years?
Again, we can look to history. Once interest rates rise from rock bottom, the increase has typically been very gradual and the latest example we have is from the financial crisis. In April of 2009 rates dropped to 2.25 percent and creeped up to 3 percent by Oct 2010, one and a half years later. It hovered around those areas and it wasn’t until Oct 2017, 8.5 years later, where rates shot above 3 percent. So as you can see rate hikes were very gradual and rates didn’t move more than 75 bps for over 8 years.
Let’s look back at variable and fixed rates in our current situation. Variable rates are 40 bps (x) cheaper than fixed rates and we’re expecting this to last for 2.5 years. This means variable rates would need to go up by 40 bps (x) above the current fixed rates or 80 bps (2x) above current variable rates in the latter 2.5 years in order for fixed rates to break even with variable rates. Based on history, it might look more like 75 bps max, which means variable rates would still be better.
Risk, Penalties & Other Considerations
Next up, let’s talk about risk. Fixed rate mortgages seem lower risk because they offer predictable mortgage payments over your fixed term, but one thing that isn’t highlighted as much is that it becomes higher risk if you need to break your contract. So if you are a real estate investor and you are thinking about regularly refinance your existing mortgages so you can pull equity out to buy new properties, this is for you.
On a fixed rate mortgage, penalties can be very high because they are calculated based on the interest rate differentials between your fixed rate and the current posted rates. So if you have a $600,000 mortgage fixed at 3.5 percent with a 3 year loan term left, you have to pay approximately a $34,000 penalty to break the contract.
On the other hand, if you have a variable mortgage at 3.5 percent, you penalty is equal to 3 months of interest or around $4,000. A $30,000 savings in penalty costs on a variable rate mortgage is a HUGE difference especially if you’re looking to use this money to buy another property. Based on a 20 percent downpayment, you can afford a property that’s $150,000 more with the variable rate mortgage, and this can mean the difference between affording a condo investment with lower more volatile returns OR getting a house with better more stable returns.
Here’s an extra note – a fixed rate mortgage is only fixed for your term. Once the term ends, you’ll be subject to market interest rates at that time. So if you had a variable mortgage, it might actually be easier to manage finances since the interest increase was gradual compared to a fixed rate mortgage which can potentially be a bigger shock all at once if you didn’t plan your cash flows properly.
How We Can Help
If you’re still not sure what to choose, we’re here for you. When you work with us, we don’t just help you buy a property, we’re with you throughout your entire real estate investing journey. So if you let us know what your long term plans are, we can help you with the most effective long term real estate investment strategy, such as which lenders to go with at different stages of your investing journey and the types of mortgages is best for you.
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