Variable-rate versus fixed-rate mortgages

Mortgage basics

Before diving into the different forms of mortgages, lets look at some of the basic components of a mortgage. These components are the things that vary between different mortgage types, so it’s important to understand what you’re dealing with.

First, what is a mortgage?

A mortgage is a type of loan that people generally take out when they want to buy a home, or other piece of real estate. The purchased property becomes the collateral for the loan. That is, if the person who took out the loan doesn’t pay it back, the lender will take over ownership of the property.

Now, here are the main components that vary between mortgage types:

Amortization period and mortgage term

The amortization period is the total length of time the borrower will take to repay their mortgage. In Canada, this is commonly as long as 30 years.

The mortgage term, meanwhile, is a shorter chunk of time within the amortization period. When you get a mortgage, you are committing to a lender and a mortgage type (including interest rates, terms, and conditions) for a set term. In Canada, 5 years is a common mortgage term.

After the mortgage term is over, you renew your mortgage. This means you can choose a new type of mortgage, find better interest rates, or even take your mortgage to a new lender. The balance of your mortgage doesn’t change, but you might be able to find a more favourable agreement for the next term.

For most of the stuff we’re dealing with in this article, we’re talking about the mortgage term, not the amortization period.

Payment terms

When you get a mortgage, you can’t just pay what you want, like with a credit card or line of credit.

The terms of a mortgage dictate how much you pay, and how often. Some allow more flexibility (we’ll get to that), but with most mortgages you’ll be paying a predetermined amount throughout your mortgage term. Mortgage payments can be weekly, bi-weekly, monthly.

That also usually includes restrictions on paying off your mortgage early—many mortgages impose penalties for doing so.

You can estimate what your payments would be under various payment terms using an online mortgage payment calculator.

Interest rate

The interest rate is one of the most important components of a mortgage. Interest is the money the lender charges you for the loan, expressed as a percentage. That percentage of the outstanding loan gets added to the balance annually. You have to pay back both the principal and the interest, so lower interest rates are always better.

Even dropping your interest by a fraction of a percentage point can save you thousands of dollars over the course of your mortgage.

Mortgage lenders change their offered interest rates constantly, so it’s worth shopping around. There are essentially two types of mortgages when it comes to interest rates: fixed and variable. But which is best?

“There are pros and cons to consider for both product types,” says Chana Charach, Mortgage Expert with INCOME.ca. “The first step is to ensure that you are well informed and fully prepared to make the best choice for yourself and your family.”

With that, let’s take a look at some different mortgage types, starting with fixed-rate vs. variable-rate.

What is a fixed-rate mortgage?

A fixed-rate mortgage means your interest rate is fixed; it doesn’t change over the length of the mortgage term.

If you choose a 5-year fixed-rate mortgage at 2% interest, you know precisely how much you’re going to be paying over that 5-year period. Your payments will be the same amount, and your interest will be stable.

“A fixed-rate mortgage may have a higher interest rate than a variable-rate mortgage, but it offers stability, security, and predictability,” says Charach. “The benefit is that your interest rate will not increase throughout the entire term of your mortgage.”

What is a variable-rate mortgage?

On the other side of the coin is the variable-rate mortgage. When you choose this type, your interest rate can (and will) change over the course of your mortgage term.

“Variable-rate mortgages tend to offer a slightly lower rate than fixed-rate, but not always,” says Charach. “The risk is that this product will likely fluctuate up at some point, increasing your mortgage payment. The hope is that it may also fluctuate down and decrease your interest rate.”

Variable rates aren’t expressed in simple percentage points as fixed rates are. Variable rates are listed as “prime +/-” and then a percentage. For example, you might find a variable rate mortgage offered at “prime – 0.8%.”

The prime rate is the lender’s market interest rate, which they base all of their loans on—not just mortgages.

“A lender ties their Prime rate to the Bank of Canada’s benchmark rate,” says Mortgage Broker Andrew Thake. “However, the lenders can add a premium to it or subtract a discount from their Prime rate.

“If the Bank of Canada changes its rate, your mortgage payment or amortization may change.”

The Bank of Canada has eight fixed dates each year on which it announces rate changes (if there are any).

How to choose variable-rate vs. fixed-rate mortgages

Choosing between variable-rate and fixed-rate mortgages largely comes down to how much you value predictability and stability.

“With a fixed-rate mortgage, you will have no surprises for the term’s length, and you will know how much interest rate you will be paying throughout the term,” says Thake. “However, you may want to consider a variable mortgage rate if you have a flexible budget and feel comfortable with the fluctuating interest rates. It is also possible to finish paying off your mortgage much faster.”

In the big picture, variable rate mortgages generally end up with lower interest rates on average. Studies have shown that, historically, variable-rate mortgages are cheaper than fixed 70-80% of the time.

If you’re not comfortable with that 20-30% chance of higher interest rates, a fixed-rate mortgage might be your best bet. And of course, taking a more focused view of recent history, variable rate mortgages saw nigh-unprecedented rate hikes in 2022.

As an example, we can look back on historical interest rates:

If you had secured a mortgage in January 2017, you could have locked in a 5-year fixed rate at around 2.4% or chosen a 5-year variable rate starting at around 1.9%.

Based on average interest rate data from ratehub.ca, here’s what your mortgage’s interest rates might have looked like between 2017 and 2022 based on those options (assuming your interest was calculated monthly):

Of course, these are estimates, but you can see how the fixed-rate interest is totally predictable, while the variable-rate interest jumps up and down. In this timeframe, the variable rate option was much cheaper—until suddenly it wasn’t. The financial environment of 2022 wasn’t typical, but it still highlights the relative unpredictability of variable rate mortgages.

Given that interest rates are in a constant state of flux, you also need to consider what the present market is like when you’re searching for a mortgage.

“When interest rates are low and are unlikely to fall further, many borrowers prefer to lock into a fixed-rate,” says Charach.

But there are other advantages of fixed-rate mortgages, too:

“Another benefit of a fixed-rate mortgage is that qualification may be more straightforward,” says Charach. “The lender does not have to factor in potential rate increases. It is important to note that pre-payment penalties may be higher if you break a fixed-term mortgage early. Lenders usually calculate a 3-month interest penalty or interest rate differential, whichever is greater.”

The terms of many mortgages in Canada stipulate that you’re not allowed to pay off the mortgage faster than the agreed-upon rate. In these cases, you’ll need to pay a penalty if you decide to pay off your mortgage early. As Charach says, those penalties tend to be higher on fixed-term mortgages.

When it comes down to it, here are Charach’s suggestions for choosing fixed vs. variable mortgages:

Fixed-rate mortgages are most suitable for borrowers who:

• Are not planning to pay the mortgage off early
• Are rate-sensitive
• Are first-time buyers
• Are on a tight budget
• Have a growing family

Variable-rate mortgages are most suitable for borrowers who:

• Have a high net worth
• Have a moderate risk tolerance
• Have more than the minimum income they need to qualify for the mortgage
• Have a stable income
• Are planning on paying off the mortgage in the short term

Speaking of paying off the mortgage early, that’s where we get into the next category: open vs. closed mortgages.

What is an open mortgage?

As we’ve alluded to, many mortgages do not allow the borrower to pay off their debt earlier than planned. Or at least they impose penalties for doing so.

Open mortgages do not have such restrictions.

If you have an open mortgage, you may pay off your mortgage early, either by increasing your regular payments or with extra lump-sum payments.

“Although this type of mortgage is generally more expensive than a ‘closed’ mortgage,” says Charach, “the borrower may prepay in part or full without notice or penalty—ideally suited for short-term mortgage needs.”

Open mortgages are all about flexibility.

What is a closed mortgage?

Unlike open mortgages, closed mortgages don’t offer much flexibility at all when it comes to repayment.

When you sign on for a closed mortgage, part of what you’re agreeing to is the payment schedule. You’ll be paying a set amount of money over a predetermined period of time.

On a fixed-rate closed mortgage, you’d pay the same amount of money every month until the term expires. On a variable-rate closed mortgage, your monthly payments would go up or down with your interest rate, but they’ll still be set by your lender.

If you wish to repay your mortgage faster, your lender will charge you a penalty for doing so. That penalty varies depending on the type of mortgage you have:

“One of the benefits [of a variable-rate product] is that the pre-payment penalties are often lower than a fixed-rate mortgage, as many lenders only charge a 3-month interest penalty if you break your variable-rate mortgage early,” says Charach.

In Canada, most mortgages are closed mortgages. Though they lack the flexibility of open mortgages, they benefit from lower interest rates.

How to choose between open vs. closed mortgages

Sometimes, you don’t have much of a choice between open or closed mortgages. If you’re looking for the best rate, you’ll pretty much have to take a closed mortgage.

“A closed mortgage has a much lower interest rate compared to open mortgages,” says Thake.

As mentioned, the majority of borrowers opt for closed mortgages. The money savings make the extra restrictions worthwhile.

There are a few scenarios in which a borrower might want extra flexibility, though:

“Consider getting an open mortgage if you intend on selling your home soon or expecting cash to pay off a lump sum of your mortgage with minimal penalty,” says Thake. “However, if this is not the case for you, you may want to stick to the closed mortgages, especially if they offer lower interest rates.”

So, unless you’re expecting a large windfall of cash in the near- to mid-future, like an inheritance or a big investment payoff, you’re probably best served by a closed mortgage.

Hopefully, now you’ve got an idea of the pros and cons of the different mortgage types. The mortgage product you choose will come down to your personal situation: are you willing to accept some risk in exchange for a shot at lower rates? Do you need flexible repayment options? Questions like these will help you decide which mortgage is best for you.

Remember: regardless of which type of mortgage you get, your lender will still require you to have an active home insurance policy throughout the entire repayment period (and you should still have one after it’s paid off, too). The mortgage lender would be what’s known as a loss payee on your home insurance policy.

Want to learn more? Visit our Home Buying, Selling and Moving resource centre for everything you need to know about real estate, buying a home, or moving. Or, get an online quote in under 5 minutes and find out how affordable personalized home insurance can be.