5-year fixed vs variable: which makes sense in today's market

The mortgage landscape is always shifting, and right now, many of my clients are asking the same question: should I go with a 5-year fixed rate or a variable rate? It's a great question, especially with the narrowing gap between these two popular options. For a long time, variable rates offered a significant discount, but that's not always the case anymore. Understanding the trade-offs is key to making the best decision for your financial future.

Understanding Fixed-Rate Mortgages

A fixed-rate mortgage means your interest rate, and therefore your mortgage payment, stays the same for the entire term, typically five years in Canada. This predictability is a huge draw for many homeowners. You know exactly what you'll be paying each month, making budgeting straightforward and stress-free.

Pros of a Fixed Rate:

• Payment Stability: Your payments remain constant, regardless of what the Bank of Canada does with its overnight rate. This offers peace of mind and makes financial planning easier.
• Budgeting Certainty: Knowing your exact housing cost allows for more precise budgeting for other expenses and savings goals.
• Protection from Rate Hikes: If interest rates rise significantly during your term, you're shielded from those increases.

Cons of a Fixed Rate:

• Less Flexibility: Breaking a fixed-rate mortgage early can come with substantial prepayment penalties. These penalties are often calculated based on the "Interest Rate Differential" (IRD), which can be quite high if rates have fallen since you locked in.
• Missing Out on Rate Drops: If interest rates fall, your fixed rate won't decrease, meaning you could be paying more than those with variable rates.
• Typically Higher Initial Rate: Historically, fixed rates have often started higher than variable rates, although this gap has recently narrowed considerably.

Exploring Variable-Rate Mortgages

With a variable-rate mortgage, your interest rate fluctuates with the Bank of Canada's overnight rate. When the Bank of Canada raises or lowers its rate, your mortgage rate typically moves in tandem. There are generally two types of variable mortgages:

• Adjustable-Rate Mortgages (ARM): Your monthly payment changes as the interest rate changes. If rates go up, your payment goes up. If rates go down, your payment goes down.
• Variable-Rate Mortgages (VRM) with Fixed Payments: Your monthly payment remains constant, but the amount of that payment that goes towards interest versus principal changes. If rates rise, more of your payment goes to interest, and less to principal, meaning it takes longer to pay off your mortgage. If rates fall, more goes to principal, and you pay it off faster.

Pros of a Variable Rate:

• Potential for Lower Interest Costs: Historically, variable rates have often outperformed fixed rates over the long term, especially during periods of stable or falling interest rates.
• Lower Prepayment Penalties: Penalties for breaking a variable mortgage are usually much simpler and less costly, often just three months' interest. This offers more flexibility if your plans change.
• Benefit from Rate Drops: If the Bank of Canada lowers its overnight rate, your mortgage payments (or the principal portion of them) will decrease.

Cons of a Variable Rate:

• Payment Volatility: Your mortgage payments can increase if interest rates rise, potentially straining your budget.
• Budgeting Uncertainty: The fluctuating nature of payments can make long-term financial planning more challenging.
• Risk of Rate Hikes: If rates rise significantly, you could find yourself paying considerably more each month, or taking much longer to pay down your principal.

The Current Market: A Narrowing Spread

For a while, the difference between fixed and variable rates was quite substantial, making variable rates very attractive for those comfortable with some risk. However, we've seen that spread narrow considerably. This means the initial interest rate for a 5-year fixed mortgage might be very close to, or even lower than, a variable rate. This shift is largely due to market expectations about future interest rate movements and bond yields, which influence fixed rates.

This narrowing spread makes the decision even more nuanced. It's no longer a clear-cut case of "variable is cheaper." Now, it's about weighing the value of payment stability against the potential for future rate decreases and the flexibility of lower prepayment penalties.

What to Consider When Making Your Choice

When deciding between a fixed and variable rate, it's crucial to look beyond just the current numbers and consider your personal financial situation, risk tolerance, and future plans.

1. Your Risk Tolerance: Are you comfortable with the idea of your mortgage payments potentially increasing? Or do you prefer the certainty of a predictable payment, even if it means potentially missing out on future rate drops? If market fluctuations keep you up at night, a fixed rate might be a better fit.
2. Your Budget and Cash Flow: Can your household budget comfortably absorb a potential increase in mortgage payments? If your finances are tight, the stability of a fixed rate could provide crucial peace of mind. Remember, the mortgage stress test ensures fits your budget payments at a higher qualifying rate, but your actual budget might be tighter than that qualifying rate suggests.
3. Your Future Plans: Do you anticipate selling your home, refinancing, or making large lump-sum payments within the next five years? If so, the lower prepayment penalties associated with variable rates could be a significant advantage. For example, if you're planning to move for a job relocation in two or three years, a variable rate might offer more flexibility.
4. Market Outlook (with a grain of salt): While no one has a crystal ball, it's worth considering the general sentiment around interest rates. Are economists predicting further rate hikes, or are cuts on the horizon? Remember, these are just predictions, and the market can be unpredictable. My role is to help you understand the current landscape and potential scenarios, not to predict the future.
5. CMHC Insurance (for high-ratio mortgages): If you have less than a 20% down payment, your mortgage will be insured by CMHC (or another insurer). This doesn't directly impact your fixed vs. variable decision, but it's an important factor in your overall mortgage cost and qualification.
6. BC Property Transfer Tax: For those buying in BC, remember the Property Transfer Tax (PTT). This one-time cost is based on the fair market value of your property and is another significant expense to factor into your homebuying budget, regardless of your mortgage rate choice.
7. Mortgage Renewal: When your 5-year term is up, you'll need to renew your mortgage. This is an excellent opportunity to reassess your financial situation and the prevailing market conditions to decide whether to stick with fixed, switch to variable, or explore other options. Don't just sign the renewal offer from your existing lender; always shop around!

Ultimately, there's no universally "right" answer. The best choice depends on your individual circumstances. My goal is to help you weigh these factors and find the mortgage solution that aligns best with your financial goals and comfort level.

FAQ

Q: Is it true that variable rates always end up cheaper than fixed rates over the long run? A: Historically, variable rates have often outperformed fixed rates over extended periods. However, this is not a guarantee. The market is dynamic, and periods of significant rate increases can make fixed rates more advantageous. It really depends on the economic cycle and your specific mortgage term.

Q: What happens if I choose a variable rate and rates go up so much that I can't afford my payments? A: This is a common concern. With an adjustable-rate mortgage, your payments would increase. With a variable rate mortgage with fixed payments, more of your payment would go to interest, and less to principal. Lenders also have a "trigger rate" or "trigger point" where your fixed payment no longer covers the interest portion, and they would contact you to discuss options like increasing your payments or making a lump-sum payment. This is why it's crucial to have a buffer in your budget.

Q: Can I switch from a variable rate to a fixed rate (or vice versa) during my mortgage term? A: Yes, most lenders allow you to convert a variable-rate mortgage to a fixed-rate mortgage at any time during your term, usually without penalty. Switching from a fixed rate to a variable rate is generally more complex and would typically incur prepayment penalties, as you would be breaking the fixed-rate contract.

Ready to Explore Your Options?

Deciding between a 5-year fixed and variable mortgage is a significant financial decision. Don't navigate it alone. I'm here to help you understand the nuances, assess your personal situation, and find the mortgage strategy that makes the most sense for you in today's market.

Take the first step towards clarity. Use my free 2-minute five-step illustration at free intake for me to review to get an estimate of what you could qualify for, or simply give me a call at 778-222-7109. Let's make sure your mortgage works for you.

Related mortgage resources

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