Fixed vs variable mortgage rates: differences, risks and a worked example

According to the FCAC, the lender considers factors such as: • the length of your term; • their current prime rate and posted rate; • whether you qualify for a discounted rate; • the type of interest you choose (fixed, variable or a combination); • your credit history; • whether you are self-employed. In general, a longer term comes with a higher rate, but not always. Ask for a discounted rate: the FCAC notes this could save you thousands of dollars. Shop around before you commit. A variable rate is often expressed as the lender's prime rate plus a spread. FCAC example: prime + 1%. If prime is 3.5%, your rate is 4.5%; if prime rises to 3.7%, your rate rises to 4.7%.

A fixed rate stays the same for the entire term. According to the FCAC, it is usually higher than a comparable variable rate. The FCAC says a fixed-rate mortgage may suit you if you want to: • keep the same payments throughout the term; • know in advance how much principal you will have paid by the end of the term; • keep the same rate because you think market rates will rise.

A variable rate can rise or fall during the term. It may start lower than a fixed rate, but the FCAC notes that rate moves are hard to predict. Between 2005 and 2015, according to the FCAC, interest rates ranged from 0.5% to 4.75%. Fixed payments with a variable rate. If the rate rises, more of each payment goes to interest and less to principal. If the rate falls, more goes to principal. The FCAC warns you could reach a point where none of the payment reduces principal, and the balance increases. Your lender may also raise your payments if rates hit a trigger rate set out in your contract, so the mortgage is paid off within the amortization period. You may need to put more toward principal to avoid problems at renewal. If you have a variable-rate mortgage with fixed payments, the FCAC recommends contacting your financial institution as soon as possible to discuss your options. Adjustable payments with a variable rate. The payment amount changes when the rate changes. A fixed amount of each payment goes to principal; the interest share varies. You know in advance how much principal you will have paid by the end of the term. Ask yourself, as the FCAC suggests, whether your budget can handle higher payments. If not, a fixed rate, or a variable rate with fixed payments only if you understand the risk, may fit better.

According to the FCAC, ask your lender whether they offer: • an interest rate cap: you never pay more than that maximum, even if market rates rise further; • a convertibility option: switch to a fixed rate during the term. Fees and conditions usually apply, and the new fixed rate may be higher than the variable rate you were paying. A hybrid or combination mortgage splits the loan between a fixed portion and a variable portion. The fixed part offers partial protection if rates rise; the variable part may benefit if rates fall. The two parts may have different terms, which, according to the FCAC, can make transferring to another lender harder. Also consider prepayment penalties if you break your contract before the end of the term (sale, refinancing, payoff). According to the FCAC, the penalty is usually the higher of 3 months' interest on the amount you owe and the interest rate differential (IRD), which usually applies if your rate is higher than the current rate. Administration fees may also apply. Your contract sets out the method: ask your lender how it applies to fixed and variable rates. For term vs amortization and how each payment splits between interest and principal, see also Mortgage amortization and our mortgage calculator.

The rates below are hypothetical (illustrations). They are not current market rates. Our calculations use semi-annual compounding; your contract states your lender's method. Common assumptions: $300,000 loan, 25-year amortization, monthly payments. • Fixed at 4.50%: monthly payment of $1,660.42. • Variable starting at 3.50%: monthly payment of $1,497.81 (payment set at the start). First month with the $1,497.81 variable payment: • at 3.50%: about $868.69 interest and $629.12 principal; • if the rate rises to 4.50% (+1 point): about $1,114.60 interest and $383.21 principal; • if the rate rises to 5.50% (+2 points): about $1,359.50 interest and $138.31 principal. With that same $1,497.81 payment, the rate at which the first month's interest would absorb the whole payment (approximate trigger at the starting balance) is around 6.07%. Beyond that, the balance can grow if the payment is not raised. The exact trigger is in your contract. Over a 5-year term, keeping the variable payment at $1,497.81 (except for the fixed scenario, which has its own payment): • A. Fixed at 4.50%: about $63,014 interest, $36,611 principal repaid, balance about $263,389. • B. Variable at 3.50% throughout: about $48,709 interest, $41,160 principal, balance about $258,840. • C. Variable: 3.50% for one year, then 4.50%: about $60,607 interest, $29,261 principal, balance about $270,739. • D. Variable: 3.50% for one year, then 5.50%: about $72,941 interest, $16,928 principal, balance about $283,072. Reading: if the variable rate stays low (B), you pay less interest and repay more principal than with the fixed rate (A), with a lower monthly payment. If the rate rises by 1 or 2 points after one year while the payment stays the same (C and D), you repay much less principal and reach renewal with a higher balance than with the fixed rate. This is not a forecast: it is the mechanical effect of a rate increase on a fixed-payment variable mortgage. With adjustable payments, the payment itself would change: about $1,497.81 at 3.50%, $1,660.42 at 4.50% and $1,831.17 at 5.50% if the rate were at that level from the start, for the same loan and amortization period. If the increase happens during the term, the payment is recalculated on the remaining balance and would be slightly different. Run your own numbers with the mortgage calculator.

• What is the current spread between your fixed and variable rates for a comparable term? • Will my payments be fixed or adjustable if I choose variable? • What is the trigger rate, and what happens if I reach it? • Can I convert to a fixed rate? Fees, conditions, and at what rate? • Is there a rate cap? • What are the prepayment penalties for each option?