Fixed or variable rate mortgage.

How’s your stomach for risk?

daryl-article

When you take out a mortgage you have the choice of borrowing at a fixed or a variable interest rate. What’s the difference between these and how do you decide which one is best for you?

In a fixed-rate mortgage, the interest rate is fixed for the entire mortgage term – the length of time that you commit to the agreement. Terms usually range from 6 months to 10 years.  During this period, both your mortgage payments and the interest rate are fixed.  Each mortgage payment has an interest component and some repayment of the amount you originally borrowed (the principal), and as the principal is repaid, the interest component of each scheduled payment gets smaller.

In a variable-rate mortgage, the interest rate varies with the prime lending rate set by the lender: it can go up or down. The prime lending rate is the rate at which banks lend to their most credit-worthy customers. Variable interest rates are usually quoted as prime plus or minus a specified amount, e.g., say prime – 0.25%. So if the prime rate is 3.0%, the corresponding interest rate would be 3.0%-0.25%=2.75%. Even if your mortgage payments are fixed, the interest component increases if rates go up and decreases if rates go down. So how much of your mortgage payment goes towards interest depends both on how much you have left to pay off and the interest rate.

Whether you should opt for a fixed- or a variable-rate mortgage really boils down to how much risk you can handle. If the mere thought of a 0.25% increase in interest rate stresses you out completely, then a variable-rate mortgage is not for you. Similarly, if the household budget is already stretched to the max and an increase in your mortgage payments would mean having to borrow on your credit card, then you should opt for a fixed-rate mortgage.

But if your financial situation means that you can tolerate small increases in the interest rate and you won’t lose sleep over the prospect, then you’re better off choosing a variable-rate mortgage.  Basically, with a fixed-rate mortgage, you pay a premium for stability. You can think of it as an insurance policy in which you pay a little extra to remove the risk that lending rates increase. But studies have shown that Canadian consumers are usually better off with variable-rate mortgages.

Moshe A. Milevsky at the Schulich School of Business in Toronto analyzed mortgage rates from 1950 to 2000 using data from the Bank of Canada. He found that Canadian consumers will, on average, save money by financing a mortgage with a short-term variable interest rate, compared to a long-term fixed rate. He showed that on a $100,000 mortgage with a 15-year amortization period, Canadians would have saved approximately $22,000 in interest payments by borrowing at prime and renewing annually, compared to borrowing and renewing at a five-year fixed rate.

So in the long run you’d expect to save money with a variable-rate mortgage. But this doesn’t mean that every person will be better off by opting for a variable rate. And if you’re on a tight budget and not able to cope with fluctuations in mortgage payments, then stick with a long-term fixed-rate mortgage. Your sleep is worth the extra money.