Fixed vs variable Rate?

Fixed vs Variable Rate?

With rates at 21-year highs and an estimated 3.4 million Canadians facing mortgage renewal before 2025, anxiety about interest rates is permeating conversations like many of us have never seen. Cost of living is top-of-mind for all Canadians as we try to find our footing in a world where grocery prices has gone through the roof, car payments are ballooning and every time we turn around we are shelling out more and more for things we took for granted just a few short years ago. In an effort to save pennies in every way possible, the decision of whether to renew into a fixed rate or a variable rate mortgage is one that feels more crucial than ever. It’s a decision that has the potential to impact a family’s financial health for years to come and could either cost or save you thousands of dollars in interest.

The Bank of Canada has made a series of interest rate hikes over the past year and a half that have brought variable mortgage rates from historical lows of 1.5% to 21-year highs of 7% and up. There is still the possibility that we haven’t seen the last of the rate hikes. However, most economists at least agree that, if we aren’t at the peak of the rate hike cycle, we are very near the top.

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Fixed rates, while not dictated by the Bank of Canada, have followed a similar trajectory to their variable rate counterpart. Fixed rates are tied to bond yields. As bond yields rise, so do fixed mortgage rates. And bond yields have risen steadily. Good news for the economy generally leads to increased bond yields while bad news and a poor economic outlook result in decreases to bond yields. Despite the gloomy economic outlook we hear from the media, rising bond yields are actually indicative of the sometimes surprising resiliency of the economic data.

Thus far, unemployment has remained largely unaffected by higher interest rates. Despite households having to manage higher shelter costs and the ever higher cost-of-living,  defaults on debts hold steady at rates that are comparable to pre-pandemic levels. Despite the doom and gloom we hear from the media on a daily basis, by-in-large, the market has been betting against a recession. In short, while households and media have been focused on high rates and spreading a decidedly negative sentiment, the bond market hasn’t agreed. And, as I said before, it takes bad news to bring bond yields lower.

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However, we may be approaching somewhat of a turning point. GDP is flatlining while the Canadian population balloons. We added over 1 million people to Canadas population between June 2022 and July 2023 and created 387 thousand jobs in 2023 but our output has failed to increase. Inflation continues to decrease steadily; although not at the pace the BoC would like to see. However, the full effect on an interest rate hike is not felt until 18 or even 24 months after the rate increase takes effect. The first rate hike happened in March 2022. The most recent only a handful of months ago. So, as we begin to see the effect of these increases work their way through the economy and acknowledge that their effects will likely only be amplified in the coming weeks and months, many feel that further rate increases are becoming less and less likely and the conversation is beginning to turn to when we will see them decrease again.

As folks begin to bet on rate decreases being implemented in the coming year, variable rates have again become a topic of conversation where a year ago it was a non-starter. Let’s take a look at the reasons for and against choosing a variable-rate mortgage.

Pros of a variable rate mortgage

• if rates begin to decrease, you can enjoy the benefits of the lower rates without having to break your current mortgage
• variable rate mortgages historically lead to cost savings
• variable rate mortgages have lower prepayment penalties in a decreasing interest rate environment so it will likely to less expensive to break a variable rate mortgage, if the need arises
• a variable rate mortgage can be locked in to a fixed rate at any time without penalty

Pros of a fixed-rate mortgage

• your rate is locked in and can’t increase if the Bank of Canada increases rates again
• your payment remains stable at an amount that you already know is within your budget
• budgeting is easier with a payment that doesn’t fluctuate
• currently, fixed rates are lower than variable rate options
• because fixed rates are lower, they allow borrowers to be approved for larger mortgages (this will likely become an even bigger factor as fixed rates are expected to fall before the bank of Canada begins to decrease its overnight rate)
• less stress; you can “set it and forget it” until the end of your next term

While short-term fixed rates are still the popular choice amongst borrowers, the variable rate option is becoming part of the conversation once again due to its potential to amount to savings over the long-term as interest rates decrease in the years to come. Variable rate borrowers are accepting the risk that the Bank of Canada may still have one more rate hike in their arsenal but banking on the savings in the final years of their term outweighing the extra they are paying now.

For those who cannot withstand another potential rate increase or who need a lower rate to qualify for their mortgage, shorter term fixed rates are a popular choice. A 2-3 year fixed allows a borrower to enjoy the security of a fixed rate without committing to that rate for too long. While the 5-year mortgage has been the standard choice for Canadian mortgage holders for decades and generally offers the lowest rate option, the potential to be locking in at the height of interest rates for longer than necessary tends not to be an attractive option.

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