If I had a nickel for every time this question has come up in discussion ….
First, let’s discuss some mortgage mechanics and terminology (this will come in handy later). In essence, a mortgage is a loan secured by the property it finances. For illustration purposes*, we will use a loan amount of $101,000 with monthly payments of $1,000 and an annual interest rate of 6%. The following illustration provides a high-level overview of the mathematical relationship between the interest rate, the loan amount and the monthly payments:
Balance at start of month | Payment (on 1st) | Mo Interest | Interest During Mo | Balance at end of Mo
a. $101,000 $1000 0.5% $500 $100,500
b. $100,500 $1000 0.5% $498 $99,998
c. $99,998 …. etc
*Note: I have taken some liberties to simplify this example and while the actual process is much more technical, the important concepts are explained in this illustration.
This monthly calculation repeats until the loan balance is exhausted and no further payments are required. The amount of time that takes is called the “amortization period” (typically 25 years).
The amortization period is not to be confused with the “term of the mortgage”, which represents how long the terms of for mortgage (payment amount, interest rate, etc.) are valid for. This is usually a much shorter period (typically 5 years), after which one must re-finance (that is, re-apply for another loan in the amount of whatever balance remains at that time, subject to the interest rates at that time).
With that in mind, we move on. While the term “fixed rate” is self-explanatory, more important is what we mean by the term “variable rate”.
While fixed rates are determined based on bond yields, variable rates are based on the Band of Canada’s overnight lending rate. This is the rate at which banks loan each other money for very short periods of time. Each bank uses this overnight lending rate to set its “prime rate”, and there is usually no difference among the “prime rates” of different banks (although they are all higher than the Bank of Canada’s overnight lending rate). Furthermore, banks also adjust their “prime rates” every time the Bank of Canada changes the overnight lending rate.
What may differ across banks is the margin they apply to their “prime rate” in order to determine their “variable rate”. This margin can either be negative or positive (or zero), which is why “variable rates” are always discussed as “prime + x” or “prime – x”. When you take a mortgage from a bank at a “variable rate”, the margin (x), is set for the term of the mortgage, however the “prime” piece can fluctuate as described above.
Although there are situations where variable rates can be equal to or greater than fixed rates, those situations are very rare and beyond the scope of this article. Generally, fixed rates are higher than variable rates, thus giving rise to the dilemma which this articles addresses.
Before we go on to address that question, one other technical detail we must understand is that even with a variable rate mortgage, it is common to have a fixed monthly payment. This is possible by the use of a “trigger rate” (a notional rate of interest set higher than the current variable rate). By basing the monthly mortgage payments on the higher trigger rate, the monthly payments can then be set up as a fixed amount, even if the variable rate changes (so long as it does not exceed the trigger rate). In the example above, the monthly payment would be calculated based on the same amortization period, but using the notional trigger rate, while the interest applied to the loan balance each month would be based on the actual variable rate at the time.
The basic idea in comparing fixed vs variable rate mortgages is your own personal risk tolerance. The lower the variable rate, the more attractive it is for you to choose a variable rate mortgage. On the other hand, a fixed rate gives you protection against rising interest rates.
Here is a key point which most people do not realize. Because a fixed rate acts like an insurance policy against rising interest rates, this risk is shifted from you to the bank. Also, like any insurance policy, the protection it brings comes at a premium (the banks would be foolish to give this protection away for free). These “premiums” are built into the fixed rates themselves (that is, the fixed rates are set slightly higher to compensate the bank for taking on this risk). As such, with a fixed rate mortgage, the bank is not only selling you a mortgage, but they’re also selling you interest rate protection, and some banks structure incentives for their mortgage brokers accordingly.
Having said that, how much protection are you really getting? Consider that whatever protection a fixed rate provides, it does so only for the term of your mortgage. In the US, mortgage terms can be as long as the mortgage amortization period (e.g. 25 years), while in Canada, the typical mortgage term is only 5 years. If rates have increased in 5 years from now, you’ll be in the same boat as everyone else trying to refinance.
Of course, in the US, fixed rates for a 25 year term are significantly higher than for a 5 year term (because the protection goes on for longer), however at least in that case the premium you pay protects you for the entire life of your loan (not just the first 5 years).
Also consider that because of the mechanics of how a mortgage loan is amortized (paid off), the interest rate at the start of the loan (when the principal balance is higher) is significantly more important that the interest rate later on. For example, over a 5 year mortgage term, all else being equal, the person with a variable rate of 4% for the first 2.5 years and 6% for the last 2.5 years will have a lower balance at the end 5 years (when it comes time to refinance) than the person who chose a flat 5% fixed rate for the whole term. Although it may seem that their interest rates average out to the same amount, because of the compounding effect of interest, the person who was able to take advantage of the temporarily lower variable rate will end up paying off their mortgage sooner.
Ultimately, the choice comes down to how attractive the difference is between the lower variable rate and the higher fixed rate, and how much you value the protection of a fixed rate (i.e. your risk tolerance).
You need to consider your risk profile as a whole before making a decision. For example, how would you be affected by the worst case scenario where interest rates rise above your trigger rate and require an increase in your monthly payment? If that situation would cause a significant cash flow problem for you, then perhaps the protection of a fixed rate is worth paying for. On the other hand, if this would spell disaster for you, then you may want to consider a less expensive property with a smaller mortgage loan.
One final issue to consider is taxes. If you’re purchasing an investment property, the mortgage interest is tax-deductible. As such, any extra insurance “premium” you are paying via a higher fixed rate becomes cheaper on an after-tax basis.