This post will look at some of the key considerations when considering a variable or fixed mortgage in Canada. In particular, I include two interesting findings I only discovered this weekend around variable mortgages which may have cost me thousands over the years!
Mortgage rate drivers
Before I get into the pros and cons, a bit of background on how mortgage rates are set.
Fixed
On average, fixed mortgage rates follow the same trend as the government bond yield market.
Bond yields are driven by economic factors such as unemployment, export and inflation.
Looking at a 5 year fixed rate mortgage vs a 5 year government bond yield the trends are very closely linked, with the mortgage rates being between 1 and 2 percentage points higher than the bond yields.
For example: In 2006, the 5 year bond yield rate was 4.18% and an average 5 year fixed mortgage was 5.25%. In 2019 the 5 year bond yield was 1.29% and the 5 year fixed mortgage rate was 2.54%.
Variable
Mortgage rates linked to the Bank of Canada’s prime rate.
Variable mortgage rates are driven by the same factors as bond yields, except variable rates fluctuate with movements in the prime lending rate. This is the rate at which banks lend to their most credit-worthy customers. Variable mortgage rates are typically stated as prime plus/minus a percentage discount/premium.
Worth noting here though is that the Bank of Canada’s prime rate and the prime rate of major financial institutions are NOT the same rate. Also, financial institutions are not obliged to pass on cuts to customers. For example: The Bank of Canada cuts rates by 0.25%, your bank may chose to only pass on 0.15% of that cut.
There is a really great article on this with some charts here.
Fixed mortgage
Now onto the pros and cons of each.
Pros
- Fixed interest payments
- These mortgages give you a set mortgage repayment in terms of how much interest you will pay for the term you sign up for. If the Bank of Canada’s prime rate has a significant increase, your mortgage interest will be unaffected until you are due for renewal.
- This gives young buyers a sense of security when budgeting can be tight and you don’t have much wiggle room to make up for unexpected, potentially significant increases. This is an incorrect perceived safety net which I will go into below.
Cons
- Fixed interest payments
- At the same time, if the Bank of Canada’s and your bank’s prime rate has a significant decrease, this savings will not be passed onto you and you could end up paying much more in interest for a number of years than you would if you had a variable mortgage.
- Worth noting is that historically, variable rates have proven to be less expensive over time
- Fewer pre payment/lump sum options
- Most bank’s offer at least some form of pre-payment or lump sum options before applying penalties. Our bank for example allowed you to pay off 15% of the initial mortgage amount per year before penalties would be applied. If you get a raise, a bonus or an inheritance and decide you want to start paying down your mortgage more quickly, a fixed rate mortgage will not allow for much flexibility, though 15% of 200,000$ is 30,000$ so these amounts are usually sufficient for most mortgage holders.
- Larger penalties for pre paying/switching before your term is up
- If you decide to sell or in a worst case scenario, need to sell before your term is up you could be looking at very large penalties with a fixed rate mortgage.
- Typically the bank will charge the greater of 3 months interest OR the interest rate differential. I’ll explain the impact of this a little further below.
Despite all of the cons, 66% of Canadian mortgages are fixed terms. This seems to indicate to me, that a large portion of Canadians are:
- not financially secure enough to accept a potential increase in mortgage payments even though it may save them more over the long run
- not aware of the flexible nature of variable mortgages which I will explain below
This seems to align with my notion on a slightly separate note, that people who have more money or are better at saving can get things cheaper where lower earners or bad savers are penalized.
For example: if you pay your insurance premium on a monthly basis, insurers will often charge a premium or admin charge to accommodate this. This can end up costing people who don’t have enough for a lump sum once a year 3-5% more for a lot of services. This can really add up over time.
This same concept seems to apply to fixed vs variable mortgages where the more money you have, the more risk you can take, the better savings in interest rates you can achieve.
Variable mortgage
Pros
- Potential price fluctuations
- as mentioned above, historically, variable rates have proven to be less expensive over time. If you sign up to a fixed rate mortgage and a month later the Bank of Canada’s prime rate drops, you will be stuck paying more in interest than you would on a variable mortgage.
- More flexible pre payment/lump sum options
- From what I can tell, variable rate mortgages have the same pre payment limitations as a fixed rate mortgage with the exception that the penalties for making a payment over the agreed amount are MUCH less – see below
- Lower penalties for pre paying/switching before your term is up
- From what I can tell, variable rate mortgages only charge 3 months interest for an early termination. The interest rate differential doesn’t apply for variable rate mortgages. This can provide massive savings if you need to sell before your term is up.
Cons
- Potential price fluctuations
- The biggest perceived risk of variable rate mortgages is that your monthly mortgage payment can change should markets shift. This is incorrect! With a variable rate mortgage your monthly mortgage payments will NOT change. It is the percentage of that payment which is paid off the principal that will change.
Pre-payment charges explained
Ok so we now know that if you break a fixed rate mortgage early you pay:
The greater of:
- 3 months interest OR
- an interest differential*
With a variable rate mortgage you pay:
- 3 month interest regardless of what is left on your term
What does this actually mean?
Let’s look at a scenario:
- 5 year mortgage at 3.29%
- Posted fixed mortgage rate on date of contract signing was 3.5% (you got a discount)
- 3 years in you need to sell (2 years remaining)
- Current posted market rate for 2 year fixed term is 2.5%
- Mortgage remaining: 200,000$
Fixed rate mortgage:
*An interest rate differential actually has nothing to do with the interest rate you are currently paying. The bank will take the posted rate for the term you agreed to on the day you signed your contract and take the difference of today’s posted rate for the remainder of your term. Clear as mud!
Annoyingly making something overly complex unnecessarily to keep customers in the dark about what they will actually pay.
So here’s how that works.
Interest rate differential calculation:
Posted rate at mortgage signing minus posted rate for remaining term divided by 12 to covert to monthly rate = interest rate differential factor
then
interest rate differential factor multiplied by remaining mortgage value multiplied by remaining mortgage term = early payment penalty
3.5% (0.035 – posted rate at mortgage signing)
– 2.5% (0.025 posted rate for remaining term)
/12 (to convert to monthly rate)
= 0.00083 interest rate differential factor
0.00083 * 200,000$ (remaining mortgage value) * 24 months (remaining term) = 4,000$
I’m not sure how it works if the current rate is higher than when you signed the contract. I’m assuming then that there is a negative amount in the calculation and then the 3 months interest will be the greater amount.
I’m also not sure if you have 1.5 years left, do they take a one year or a two year term for the current rate in the calculation but assuming they would take the 2 year.
The bank may also have a discharge fee which can vary from province to province, anywhere from an additional 70$ – 270$.
Variable rate mortgage
Existing mortgage rate * remaining mortgage value * 3/12 (3 months) = early penalty fee
3.29% (0.0329) * 200,000$ * 3/12 (0.25) = 1,645$ + any discharge fees (70$-270$).
Calculator
If you need it, there is calculator here that helps with this calculation but its also useful to understand the math behind it so you can sense check your figures.
My mistakes
As you many know, we have a property in Canada.
I am only JUST discovering the benefits of a variable rate mortgage. This makes me so mad! That this is BASIC financial literacy which banks should be informing you about when signing up for mortgages.
I would have considered myself fairly well researched, even at 26, when I signed my first mortgage but am only finding out about this 8 years, and 2 mortgages later!
My understanding of fixed vs variable was that variable meant that your monthly repayments could fluctuate. I wasn’t conformable with having no control over such a big expense and went for fixed. We also weren’t aware of the pre-payment differences.
When we first signed our mortgage, we bought a 1 bedroom condo downtown. Being from the country, I wasn’t sure if I was going to like living there and wasn’t willing to sign a term longer than 1 year as I wanted flexibility to sell if we needed to.
Every year thereafter, there was some question on whether we would stay there. In the second year, we LOVED living there but weren’t sure if we wanted to start a family in the next few years and would need at least one more bedroom.
Year 3 we decided to move back to Ireland and were waiting year to year to see if the market would recover enough to sell.
So we were only ever looking at the 1 year fixed options as even though I was aware that historically variable rates performed better than fixed, the shortest variable term was 3 years and I wasn’t aware that the pre-payment terms were the LEAST of what you would pay in a fixed term.
Selling soon?
Recently, I got an early mortgage renewal prompt from our bank and I was trying to figure out which options would cost us less as we were planning on selling in the next year.
The options I was looking at was
- a 6 month open term at 6.75%
- a 1 year fixed term at 3.44%
- a 2 year fixed term at 2.65%
I wasn’t even considering a variable as again it was a minimum of 3 years, though now there is a 5 year at 2.25% (prime – 0.20%)
The 6.75% option would cost us 1,000$/month in interest for every month we don’t sell but no early termination fees
The 3.44% option would cost us 510$/month in interest for every month we don’t sell but also cost us 1,530$ in early termination + 270$ discharge
The 2.65% option would cost us 393$/month in interest for every month we don’t sell but also cost us at least 1,179$ in early termination + 270$ discharge fee. It is impossible for us to known what the interest differential would be as we don’t know what the rate will be by the time we are ready to sell. In the current market I would expect the rates to go down and so there could be a differential to pay.
The lowest it’s ever been since 1935 has been 2.25% so that would be 1,424$ which is higher than the 3 months and the amount I would need to pay.
Now that I know about the variable option I think I will renew at a 5 year variable at 2.25%
This will cost us 334$/month in interest and 1,000$ in early termination fees + 270$ discharge fee.
So if I sell in month 1 after signing the renewal the 6 month open term wins but only by 333$. Every month thereafter the 5 year variable option wins out.
As I could have renewed early back in February, I could have been spending 154$/month less in interest since then had I known about this. Not to mention how much more I paid in interest over the last 8 years as I thought my only options were 1 year fixed rates for our given circumstances. I don’t have the stomach to do the math but even a fraction of a percentage difference over that term could have cost me thousands.
Here is how the 4 options pan out over 6 months. For example; If I took the 6 month open term and sold in month 1 after renewal I would be out 1,000$ in interest. If I sold in month 2, I’d be out 2,000$ in interest. If I took the 1 year fixed and sold in month 1, I would be out 2,040$ with interest and pre-payment charges and so on.
| Sell Condo in | 6.75% Open | 3.44$ 1 Yr Fixed | 2.65% 2 Yr Fixed | 2.25% 5 Yr Variable |
|---|---|---|---|---|
| Month 1 | 1,000 | 2,040 | 1,817 | 1,333 |
| Month 2 | 2,000 | 2,550 | 2,210 | 1,666 |
| Month 3 | 3,000 | 3,060 | 2,603 | 1,999 |
| Month 4 | 4,000 | 3,570 | 2,996 | 2,332 |
| Month 5 | 5,000 | 4,080 | 3,389 | 2,665 |
| Month 6 | 6,000 | 4,590 | 3,782 | 2,998 |
Don’t trust bankers
My overall feeling from all of my dealings with bankers over the years is, that they either know less than you do OR are trying to get you to pay the most in interest to them for as long as possible. This should come as no surprise really but I think young people that are in a position to buy a house may not have realized this yet.
In my latest dealing with the bank, I explained my situation and asked for guidance on which option would cost me less over all as we were looking to sell in the next year. I asked for the exact calculations so that I could do the analysis myself. They could not answer the question. They had a calculator which told them what it would cost if I sold today but couldn’t give me any more details. When I gave a specific example say: “If we go with a 2 year fixed but pay it off only 6 months in what is the penalty vs if we get a 1 year fixed and pay it off 6 months in”. The banker said with certainty, and I quote “If there is less term remaining, there will be less penalty! So in your example, 1 year fixed will save you more.” This is only partially true and with the rate differential there is no way they could actually tell me what my early penalties would be. Also to state with certainty like that with no caveats or further explanation is so dangerous. If I was the type of person to take their word for it, which a lot of people would be, they would end up costing me almost 1,000$ extra. When I compared the exact scenario I provided, once I understood the calculations, the difference between the 1 year and 2 year fixed after 6 months was 800$ more for the 1 year fixed option. They also did not opt to tell me about the variable mortgage rate which would almost certainly win out in all scenarios, and in the scenario I gave would have cost me 1,600$ MORE to go with the 1 year fixed option.
My previous dealings with another banker were even worse. They tried to get us to sign up to a 5% mortgage when there was one posted publicly on their site for 2.64%. They tried to get us to sign an open form which would allow them to change the terms of our mortgage to avoid us coming into the bank (kind of like signing a blank cheque really). There were a few other things she tried to get us to sign up for which I can’t recall but when we refused all of them, she started to get annoyed with us. Basically we weren’t going to give her an easy commission on whatever it was she was selling. She also tried to convince us that paying 40$ extra a year off our mortgage would make a big difference saying “every little helps”. While there is some truth in this, there were far more helpful tidbits she could have imparted on us if she was really trying to help. Like the difference between variable and fixed mortgage rates for instance.
With 66% of Canadians on fixed mortgage rates I really think we’re all being taken advantage of!
Unless I’ve misunderstood something, and if so please do let me know, but for now I’m sticking to my guns that bankers are not there to help you. They are there to sell products for the banks.
Bonus content
Collateral mortgage
Another thing to be aware of is a collateral mortgage which makes it more expensive for you to switch mortgage providers. Yet another way for banks to make it harder for you to get a better rate elsewhere.
When we first started out there was an offering called a “Total Equity Plan” which allowed us to split our mortgage into various products. For example 30% could be a 5 year fixed, 30% could be a 5 year variable and 40% could be a 1 year fixed. You also had the ability to take out a Home Equity line of Credit if you ever wanted to access some of the equity you had built up in your home.
At the time this sounded like a really cool way to hedge your bets against different interest rate models and allow us to access equity easily should we need to.
In reality, we only ever went with 100% on the lowest rate we could get as that was what was most important to us rather than spreading risk.
What they didn’t tell us was that this type of mortgage needs to be “dismantled” as such by a lawyer so when you go to switch mortgage providers (should you ever find a better rate elsewhere), you will need to have a lawyer process it which makes the cost of switching almost pointless.
Anyway, I’ll leave it there now that I’m all riled up I need some time to calm down before bed.
I hope this post goes far and wide to help people see the big picture math behind their options when it comes to mortgages.
And if I’m wrong somewhere please do let me know! I love to give people the benefit of the doubt but time and time again I have been proven otherwise when it comes to banks unfortunately.