Several years ago, I bought a condo. Interest rates were at record lows. The variable rate was 2.25%, and the fixed rate was 3.25%.
Which one would you have chosen?
The fixed rate guarantees the same rate for five years, providing peace of mind that the interest rate won’t rise above 3.25%. The variable rate, on the other hand, fluctuates. It could go up or down, but given that interest rates had never been this low before, the chances were high that they would increase.
My friend, who also bought a condo, chose the 3.25% fixed rate right away. To him, it was a no-brainer. Why take the risk of selecting a rate that could rise?
When I asked him why he chose the fixed rate, he replied, “I chose a fixed mortgage for stability. This way, I know exactly what I’m paying for the next five years.” He added, “Interest rates can’t go any lower than that.”
He was right. Interest rates didn’t go any lower. In fact, they went up.
So, which one did I choose?
I went with the variable rate. I’m more of a risk-taker. Even though I knew interest rates were more likely to go up than down, I couldn’t resist the lower rate.
How did my friend and I fare? Who made the better choice?
Well, we both made a better choice according to our risk tolerance.
Well, we both made the right choice based on our individual risk tolerance. My friend locked in the best rate for his comfort level. For him, it would have been irresponsible not to secure those low rates.
As for me, I was happy with my decision too. I convinced myself that it made sense to take advantage of the low variable rate, even knowing the risks.
Interest rates did rise by 0.25%. After two years of paying the low variable rate, my mortgage rate increased from 2.25% to 2.5%. My gamble paid off. I’m still paying less than if I had chosen the fixed rate of 3.25%.
Why did I choose the variable rate?
It was a gut instinct. At the time, I couldn’t have explained it clearly, but after reflecting on it, here’s my reasoning:
The Bank of Canada sets key interest rates, which then influence the prime rates of commercial banks. If the Bank of Canada raises its rates, my variable rate would go up. However, Canada is known for having a stable economy and tends to make interest rate changes gradually. Investors are attracted to countries with steady interest rate policies, so it benefits Canada not to make drastic or frequent changes.
The difference between the prime rate and my variable rate was 1%. The Bank of Canada typically adjusts rates by 0.25% at a time. For my gamble to have backfired, the Bank of Canada would have needed to raise rates more than four times in a short period.
Studies show that, historically, there’s a higher probability of paying less interest with a variable-rate mortgage compared to a fixed-rate one. Another reason I opted for the variable rate is that it’s less expensive to break a variable-rate mortgage if necessary.
Breaking a Mortgage
When you take out a mortgage, you commit to certain terms and conditions for the next five years. After that, the terms are renegotiated. However, a lot can happen in those five years—marriage, divorce, new babies, children leaving home, job relocations—that may lead you to break your mortgage early.
If you break a mortgage, penalties usually apply. The bank expects to earn a certain amount of interest as part of its revenue, so breaking a mortgage means the bank loses that income. Generally, breaking a variable-rate mortgage is cheaper than breaking a fixed-rate mortgage because banks typically earn more from fixed-rate mortgages.
People break mortgages all the time. In fact, about 50% of borrowers don’t reach the end of their five-year agreement. I learned this the hard way many years ago when I paid about $5,000 to break a mortgage. I didn’t even know about the penalty until I was signing the papers at the notary’s office. Ouch, that was painful.
For both variable and fixed interest rates, the penalty is typically three months of interest. However, since the interest rate is higher for fixed-rate mortgages, the penalty is higher too.
Most People Choose Fixed-Rate Mortgages: Studies have shown that around 70% of borrowers chose fixed-rate mortgages. This is understandable. It’s difficult to imagine rates going any lower, as my friend predicted, and it’s more likely that rates will go up, which is what we’re seeing now. However, since the increases haven’t been drastic, borrowers with variable rates are still paying less.
Ultimately, it’s all a gamble. My take is that if you have the financial resources and can handle the uncertainty of fluctuating rates, go with the variable rate. But if you prefer stability and peace of mind, the fixed rate is your best bet.