Fixed Rate or Variable Rate Mortgage?

Your Best Mortgage Options

Updated December 20, 2024

If you’re in the market for a mortgage, one key consideration is the rate type on the mortgage you choose. Will you opt for a fixed-rate mortgage or a variable-rate mortgage? Fixed rate mortgages are the most popular but does a variable-rate mortgage make sense today, now that rates have been declining?

Many borrowers that we speak with are once again asking about variable-rate mortgages. But is it the right time to consider variable-rates? There is no single answer for all borrowers since the decision depends on personal preferences and risk tolerance. However, this decision impacts your mortgage costs, payment size, and the level of risk you take with your mortgage. Let’s review some key considerations when you look into whether a fixed-rate mortgage or a variable-rate mortgage is right for you.

What are the Differences Between Fixed and Variable Rate Mortgages?

Fixed-Rate Mortgage

With a fixed-rate mortgage, your interest rate and monthly payments remain the same for the entire mortgage term. This stability is attractive, particularly in a rising interest rate environment. However, this usually comes at the cost of higher interest rates compared to variable rate mortgages. Note that this has not been true the past two years because interest rates are inverted – this means that short-term interest rates are higher than long-term interest rates. This inversion is why variable mortgage rates are currently higher than fixed mortgage rates, defying the longer-term historical norm.

Pros of a fixed rate mortgage:

• Predictable, consistent mortgage payments
• Protection from interest rate increases
• Easier to predict and manage your cash flow over time

Cons of a fixed rate mortgage:

• If interest rates decline, your rate remains unchanged
• Typically, higher interest rates than variable mortgages (although not true today)
• Higher prepayment penalties.

With recent interest rate and economic uncertainty, most borrowers are taking fixed-rate mortgages. Hoping that rates may decline over the next couple years, most are preferring short-term fixed rates, like 2-year or 3-year mortgages.

Variable-Rate Mortgage

A variable rate mortgage is one where the interest rate you pay can change over time, usually in line with the Prime Rate. The lender sets the variable mortgage rate as the Prime Rate plus or minus a margin. As the Prime Rate fluctuates, so does your mortgage rate.

Note that there are two types of variable-rate mortgages:

With either variable-rate mortgage type you pay more for the mortgage if interest rates increase. With an ARM your payments adjust as rates increase. With a VRM the impacts of rate changes are not experienced right away since your payment stays the same. That can sound convenient, but it may be stressful if your amortization increases, or your lender asks for a lump sum payment to bring the mortgage back in line.

Pros of a variable rate mortgage:

• Benefit from a declining rate environment
• Potentially lower mortgage payments when rates decline and variable rates are lower than fixed rates.
• Lower prepayment penalties.

Cons of a variable rate mortgage:

• For an ARM, the risk of increased payments if interest rates rise
• With static-pay VRM, the risk of negative amortization and/or a need for lump sum payments to keep the mortgage on schedule.
• Added stress of needing to regularly monitor market conditions

Recently, with the Bank of Canada cutting rates and the possibility of further reductions on the horizon, variable rates are once again an option to reconsider for those with the appetite to take on interest rate risk.

Mortgage Penalties

Another key consideration when considering fixed versus variable, is prepayment penalties. Fixed rate mortgages typically have higher penalties for early repayment compared to variable rate mortgages, particularly in a declining interest rate environment. If you anticipate needing to make large prepayments or break your mortgage early, this is a critical factor to consider.

The prepayment penalties on variable-rate mortgages are usually three months of interest. For fixed-rate mortgages they are usually the greater of three months of interest or the interest-rate differential (IRD). The IRD is essentially an interest rate make-whole for the lender that calculates the difference between what they currently earn on your mortgage and what they can earn on a new mortgage. As rates decline, this IRD gets larger.

Borrowers wanting prepayment flexibility tend to either choose a variable rate mortgage or a shorter-term fixed rate mortgage. This minimizes the prepayment penalties you might have to pay and provides more flexibility to handling changes to your life, such as a job relocation.

Insider Tip

Prepayment penalties at the major banks tend to be larger than at smaller financial institutions and monoline lenders.

Fixed vs Variable – What’s Best for You in Today’s Environment?

After a period of high rates where fixed-rate mortgages were dominant, the fixed vs variable mortgage question is back in the discussion. The first thing to note is that while variable-rate mortgages usually have lower rates than fixed-rate mortgages, that is not true today. The gap between the best variable mortgage rates and best fixed mortgage rates has declined but is still about 0.50%. If your decision is based solely on what you can afford today – in other words, what mortgage provides the lowest mortgage payment - then a fixed-rate mortgage is best for you. Since a fixed-rate mortgage payment is lower, you will also be able to qualify for a larger mortgage under the mortgage stress test.

Deciding between a fixed and variable rate mortgage depends on your personal situation and risk tolerance. You will likely read headlines in the news in the coming months that variable-rate mortgages are a no-brainer when rates are dropping. This makes sense for some borrowers on the surface, but deciding to take a variable-rate mortgage on that basis is a choice based on opportunity, not risk management. We believe mortgage borrowers need to consider the risk carefully, especially with their primary residence.

Let’s look at the potential benefits of a variable-rate mortgage and assess whether it makes sense today.

If you have a strong belief that rates are going to drop substantially and also have a high risk tolerance, you may want to consider a variable-rate mortgage today. You should not only have a high risk tolerance but also the financial wherewithal to manage the increased cost of a variable-rate mortgage if rates were to increase again.

Conclusion

While we are seeing more inquiries about variable-rate mortgages today, most customers still prefer a fixed-rate mortgage. The stability and predictability of a fixed-rate mortgage makes sense to most risk-averse borrowers.

It’s important to weigh the potential benefits of variable-rate mortgages against the potential risks, such as the possibility of interest rates rising, which would increase your monthly payments. Is your budget and lifestyle conducive to uncertainty with how much your mortgage will cost you?

Interest rate risk hurt many borrowers post-covid. The personal damage from taking this risk cannot be understated as some homeowners lost, or had to sell, their homes when they were no longer able to afford their variable-rate mortgage. Make your decision carefully and don’t be pressured by a salesperson or mortgage broker. The decision is personal and subject to your preferences and risk tolerance. There is never a guarantee regarding the future direction of interest rates.

As with most financial decisions, the best choice depends on your specific situation. If you would like to discuss your options, our team at Frank Mortgage is here to help you with unbiased advice and great mortgage rates. Call us at 1-888-850-1337 or visit www.frankmortgage.com to speak with a licensed mortgage agent.