For as long as there have been fixed and variable rates, there have been disagreements over which is best for a borrower. Sadly, there is no right or wrong answer, they both have their strengths and weaknesses. So let’s dive in and talk about the good, the bad, and the just plain ugly.

Let’s start by looking at the fixed interest rate. A fixed rate is just that, it’s an interest rate that will not change during the length of your term. If you pick a 5 year term, meaning your mortgage will be up for renewal in 5 years, for that entire time, your rate won’t change. That’s the main advantage of a fixed rate, you get stability. If you’re the type of person that can’t sleep at night worrying about interest rates changing or panic at the thought of your payment changing, a fixed rate is the ideal solution for you.

So what’s the downside to a fixed rate? Glad you asked, the downside is that a fixed rate will be higher than a variable rate. You’re essentially paying for that security and peace of mind. Which, again, if that’s what helps you sleep at night, then you may consider it worth it.

So far, nothing too ugly in there right? Well let’s get talking about penalties. Every mortgage has certain pre-payment privileges attached, it’s the amount you can pay towards the principle every year without penalty. So what happens if you pay more, in the event you want to refinance, want to sell and need to break your mortgage, well now you face a penalty called Interest Rate Differential.

Interest Rate Differential is a bit complex but the basics are that your mortgage provider will look at the discount you received when you initially started your term, the discount is what the posted rate for your term was, subtract your actual rate. Now that you know the discount, that number will subtracted from the posted rate that closest matches however much time is left in your term. That’s the interest you’ll have to pay. So here’s an example:

Posted 5 year Rate 4.5 %
Actual Rate – 2.5%
Discount – 2%
Mortgage Remaining – $600,000

You want to break your term with 2 years left, and the posted rate for a 2 year term is 3.5%, so we subtract your discount from (2%) from 3.5% to give you 1.5%. We now multiply $600,000 by 1.5% to give you an interest rate differential penalty of $9,000. That’s not a small chunk of pocket change for most people, hence the ugly!

Ok, so now that we’ve done a deep dive on fixed rates, let’s look at the alternative, a variable rate.

Like the name suggests, a variable rate is a rate that can change over the course of your term. It’s tied to the prime rate, so you’ll be quoted something like prime minus 1.1% giving you a rate today of 1.35%. So what happens if prime increases, well your rate will increase as well. If prime changes from it’s current 2.45% up to let’s say 2.70%, your rate will change from 1.35% to 1.60%. As a result, your payment will increase. So as I mentioned before, if you can’t sleep at night thinking about the potential for your rate to increase, this is not the product for you! So there has to be some benefit to a variable rate, right? Absolutely!

Since you’re giving up some stability, you are going to get a better rate than a fixed rate. Generally your rate will be about 1% less than a fixed rate at any given time. So there is a cost savings, however, that can disappear if rates increase significantly.

Prime rate can change 8 times a year. The Bank of Canada, pre-schedules 8 announcements a year, and at these announcements, they’ll determine if they’re going to increase the overnight borrowing rate. If they do, prime rate will increase, causing your rate to increase. Conversely, if rates decrease, your rate will decrease.

The pre-payment penalties on a variable rate mortgage are also more favourable then a fixed rate. They are simply 3 months interest. So given our example above, the penalty would be calculated as $600,000 x 2.5% divided by 12 months, then multiplied by 3 months giving us a penalty of $3,750. A difference of over $5,000.

So armed with this information, you’re now ready to decide what type of rate is best for you. It’s important to talk to your mortgage broker about your long term goals, together, you can chart an appropriate action plan and make sure you are in the rate type that works for you!