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One of the first decisions home buyers and mortgage shoppers face is whether to select a fixed or variable mortgage rate. With a fixed mortgage rate, the mortgage rate and payment you make each month will stay constant over your mortgage term. With a variable rate, however, the mortgage rate will fluctuate with the prime lending rate as set by the Bank of Canada. A variable rate will be quoted as Prime +/- a specified amount, such a Prime - 0.85%. Though the prime rate will fluctuate, the relationship to prime will stay constant over your term.


Fixed and variable mortgage rates compared

  Fixed Mortgage Rate Variable Mortgage Rate
Description Set for the duration of the mortgage term. Mortgage interest rate and payments are fixed. Fluctuates with the market interest rate, known as the 'prime rate.' Mortgage payments either fluctuate with fluctuations in the prime rate, or the interest portion of the payment varies.
 Pros Can essentially 'set it and forget it', regardless of whether rates rise or fall. Eases budgeting anxiety and offers stability. Examined historically, variable rates have proven to be less expensive over time.
 Cons If the difference between the variable and fixed rate is significant, it may not be worth paying a premium for the stability protection of a fixed rate. Consider the financial uncertainty: significant increases in the prime rate will increase your interest payable and, thus, financial burden.

 


Popularity of fixed versus variable mortgage rates

Fixed mortgage rates, at 66% of total mortgages, are most common; however, 29% of mortgages, a significant minority, do have variable rates. Fixed rates are also slightly more popular with younger age groups, while older age groups are more likely to opt for variable rates.1

  % of Mortgages
Fixed 66%
Variable 29%
Combination 4%

Source: Canadian Association of Accredited Mortgage Professionals (CAAMP) Fall 2010 Consumer Report


Comparing fixed and variable mortgage rates

You can think of the difference, or spread, between variable and fixed mortgage rates as the price of insurance that lending rates will not increase, more or less. When interest rates are low and are not expected to fall further, it is generally advised to lock in a fixed rate, as variables rates will, at best, stay the same, or increase. On the other hand, if you expect interest rates to fall with some certainty, then a variable rate is preferred, as you will be able to absorb the benefit of paying lower interest. Similarly, if the difference between the variable rate and the fixed rate is significant, it may not be worth paying the premium for the stability protection of a fixed rate.


Fixed and variable mortgage rate drivers

By and large, fixed mortgage rates follow the pattern of Canada Bond Yields, plus a spread, where bond yields are driven by economic factors such as unemployment, export and inflation.

Variable mortgage rates are driven by the same economic factors, except variable rates fluctuate with movements in the prime lending rate, the rate at which banks lend to their most credit-worthy customers. Variable mortgage rates are typically stated as prime plus/minus a percentage discount/premium. For example, a variable rate could be quoted as prime - 0.8%. So, when the prime rate is, say, 5%, you will pay 4.2% (5%-0.8%) interest.

The Bank of Canada adjusts the prime rate depending on the state of the economy, as determined by the economic factors introduced above. Together, combinations of unemployment, export, and manufacturing values shape the inflation rate. Generally speaking, when inflation is high, the Bank of Canada will increase the prime rate to make the act of borrowing money more expensive. Conversely, when inflation is low, the Bank of Canada will decrease the prime rate to stimulate the economy and improve the attractiveness of borrowing.

In terms of the discount/premium on the prime rate applied to variable rates, mortgage lenders set this based on their desired market share, competition, marketing strategy and general credit market conditions. These are the same factors that drive the spread between lenders' fixed mortgage rates and bond yields.

 

[1] CAAMP Fall 2010 Consumer Report

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