Is it Still Better to Get a Variable-Rate Mortgage Over a Fixed One? 

A variable rate mortgage is different from a fixed-rate mortgage because the interest rate and payment amount change with the interest rate of the Bank of Canada. For example, if the Bank of Canada rate decreases, so will your mortgage payments on a variable rate mortgage. However, your payments won’t change over your term with a fixed-rate mortgage.

Generally, it’s advised to get a variable rate mortgage when interest rates are expected to drop. This is because your mortgage payments decrease. However, it is not always best to lock in a fixed-rate mortgage when interest rates are expected to rise. Continue reading to find out why.

Why Interest Rates Change

Interest rates impact how fast an economy can grow. Low interest rates stimulate the economy because it’s cheap to borrow money to buy houses, invest in factories or hire new employees. In a period of prolonged low interest rates, the economy grows because more people buy homes, invest in factories, and hire more employees. However, the cost of these activities increases because there is more demand for them. This is known as inflation which is why housing markets across Canada are becoming significantly more expensive.

To combat the price inflation of these objects, the Bank of Canada must increase the interest rates. When the interest rates rise, it suddenly becomes more expensive to borrow money and buy houses, invest in factories, and hire employees. This reduces the demand for these objects, which cools down inflation. You can think of interest rates as a lever the Bank of Canada operates to balance economic growth with inflation.

When Covid-19 hit Canada, it devastated the economy. The Bank of Canada decreased interest rates to record lows to combat the damage. These low interest rates helped sustain economic damage because businesses could cheaply borrow money to pay rent, employee salaries, etc. However, these low interest rates caused significant inflation that resulted in housing markets across Canada shooting up in value. Low interest rates meant Canadians could borrow more money to buy real estate. To cool the inflation, it is expected the bank of Canada will increase interest rates over the coming years.

How Interest Rate Changes Affect your Variable Mortgage Rate

As mentioned previously, rising Bank of Canada interest rates increases your mortgage rate. Variable-rate mortgages change with the Bank of Canada rate. This means the Bank of Canada rate hike will increase your variable mortgage rate.

Comparing the Spread Between Fixed and Variable Rates

Although it’s generally advised to lock in a fixed rate when interest rates are expected to rise, this is not always the case. Many people forget to compare the rate difference between variable and fixed-rate mortgages. The difference between the two rates is known as a spread. According to WOWA, the spread between the variable rate mortgage and fixed rate is 1.39%. This means a five-year fixed mortgage rate is currently 1.39% higher than a five-year variable rate mortgage.

The next step is to predict if the Bank of Canada’s interest rate will rise by more than 1.39% over the next five years. Desjardins Bank Predicts interest rates will increase by 0.75% – 2.75% over the next few years. However, rates increase gradually, meaning that you may not experience higher interest rates until a few years into your term. Most likely, the variable and fixed rate will average to a similar amount during the five years. A variable rate may be slightly better over the five years, but nothing is for certain. If you are someone who wants a guaranteed monthly payment that won’t increase, a fixed-rate could be better for you.  

Thus, a variable rate may be slightly better than a fixed rate over the next five years. This is because the interest rates will rise slowly. Even if your variable interest rate increases above 1.39% in your fourth year, what matters is the average rate you paid throughout the five years. However, if you prefer to have a predictable monthly payment, and don’t like the uncertainties of interest rates, then you may prefer a fixed-rate mortgage. 

What are Capped Variable Rates

A capped variable rate means your variable interest rate can only increase by a certain percentage each year. For example, your variable rate could be capped at a 1.39% increase. This means if interest rates rise by 2%, you’d only pay for the 1.39% difference. Then if interest rates increase again, you’d still only pay for the maximum capped amount. This is an excellent strategy to receive the lower variable rate mortgage today yet still be protected when interest rates rise.

What are Hybrid Mortgages

Some lenders may also offer hybrid mortgages, a combination of variable and fixed-rate mortgages. You can choose the percentage breakdown of your fixed and variable rate portions. For example, you may choose a 70/30 split where 70% of your mortgage is variable while the other 30% is fixed. This means an interest rate increase will affect you less because of the fixed-rate portion.

Historical Interest Rate Changes in Canada

Before 1990, interest rates in Canada ranged between 10-15%. However, in 1981, Canadian interest rates spiked to around 20%. Over the next five years, interest rates decreased dramatically because the high rates severely impacted the economy.

Interest rates increased again during 2003-2004, but not as dramatically as in previous years. Interest rates continued to grow until 2007, which gradually led to the 2008 financial crisis. At that time, Canada was one of the first G7 countries to recover from such a negative economic downturn.

Interest rates have hovered below 1% after 2008 but rose to 1.75% in 2017 to combat inflation. However, during Covid, rates were slashed to 0.25%. It is expected interest rates will increase throughout the 2020s to combat almost two decades of low interest rates causing inflation.

The Bottom Line

Overall, a variable rate mortgage will likely have lower interest rates but a fixed-rate mortgage,  which follows the 5-year government bond yields, won’t change. Both mortgage rates will likely be similar so the decision rests on your preference between comfort, or risk-taking. There will likely be interest rate hikes because the Bank of Canada needs to cool down the economy after record interest rate cuts throughout Covid-19. However, rate increases happen slowly and will likely increase towards the end of your five years. Additionally, a variable rate mortgage could be better with enhanced options such as a capped rate or hybrid mortgage. These strategies allow you to receive lower interest rates now and be protected when interest rates rise.