The Difference Between a Fixed Rate Mortgage and a Variable Rate Mortgage

You make many important decisions when choosing a mortgage, but one of the first and most important is between the fixed rate and variable rate mortgage.

Check out the differences between the two to help you decide.

Understanding the Fixed Rate Mortgage

The fixed rate mortgage is a predictable option. Your interest rate remains the same for the term. Borrowers with fixed income or that prefer a predictable budget often choose the fixed rate mortgage. Fluctuating interest rates don’t affect your payment, but you may pay a higher rate for the predictability.

Pros and Cons of the Fixed Rate Mortgage

Pros:

• Provide financial stability because you always know your mortgage payment
• Provides peace of mind because you don’t have to worry about changing prime rates

Cons:

• You pay a ‘premium’ for the loan’s stability in the higher rate
• There’s no guarantee your fixed rate will cost less than the variable rate3 months interest or IRD (Interest Rate Differential), whichever is greater if broken early

Understanding the Variable Rate Mortgage

The variable rate mortgage interest rate adjusts throughout the life of your loan. It adjusts according to the prime rate and the premium or discount set by your lender. Your premium or discount never changes throughout the life of the loan. The prime rate, however, changes, based on the Bank of Canada’s overnight lending rate.

If the prime rate changes, your mortgage rate changes. Here’s an example. Your lender offers you an interest rate of prime plus 0.5% and when you bought your home, the prime rate was 3%. Your mortgage interest rate was 3.5%. Two years later the prime rate changes to 3.5%, so your interest rate increased to 4%, changing your mortgage payment for the duration of the latest prime rate or your term.

Pros and Cons of the Variable Rate Mortgage

Pros:

• 3 months interest if broken early
• Variable rates are often lower than the fixed rate (but there’s no guarantee)
• You can take advantage of falling interest rates, resulting in a lower mortgage payment
• Can switch to a fixed rate mortgage at any time

Cons:

• Variable rates create financial uncertainty as rates can increase
• Variable rates may cost more over the loan’s term if rates increase

What Should you Choose?

Choosing between a fixed and variable rate is a personal decision. When interest rates are already low, many borrowers choose the fixed rate. You lock in the low rate and don’t have to worry about an increasing mortgage payment.

If rates are on the higher end or you think rates may decrease in the future, you can take a chance on the variable rate mortgage. If rates fall, you get the benefit of the lower mortgage payment. Many borrowers choose the variable rate when the difference between the fixed and variable rate is negligible, as there’s no reason to pay the premium for a fixed rate when variable rates have the chance to fall.