Fixed vs. Variable Mortgage Rates, What’s the Deal?

By MLD Wealth Management Team –

One of the first decisions homebuyers and mortgage shoppers face is whether to select a fixed rate or variable rate mortgage.

With a fixed mortgage rate, the rate and payment you make each month will remain constant over your mortgage term. With a variable rate, however, the mortgage rate will fluctuate with the prime lending rate as set by the Bank of Canada.

You can think of the difference between variable and fixed mortgage rates as the ‘price of insurance’ to protect you against rising lending rates. When interest rates are low and not expected to fall further, it is generally advised to lock in a fixed rate, as variables rates will typically stay the same or increase.

On the other hand, if you expect interest rates to fall, then a variable rate is preferred, as you will be able to capture the benefits of paying lower interest. Similarly, if the difference between the variable rate and the fixed rate is significant, it may not be worth paying the premium for the stability protection of a fixed rate.

Setting Variable Mortgage Rates

Fixed mortgage rates follow the pattern of Canadian Bond Yields, plus a spread (or profit), where bond yields are driven by economic factors such as unemployment, export, and inflation.
Variable mortgage rates are driven by the same economic factors, except variable rates fluctuate with movements in the prime lending rate, the rate at which banks lend to their most creditworthy customers. Variable mortgage rates are typically stated as Prime +/- a percentage discount or premium. For example, a variable rate could be quoted as Prime -0.5%. So, when the prime rate is 3.5%, you will pay 3% interest.

Prime is the benchmark interest rate used by major banks when pricing for short-term loans. It is directly influenced by the Bank of Canada’s overnight lending rate and can fluctuate on a monthly basis.

Over the last 25 years, the Bank of Canada has made changes to the prime lending rate an average of 6 times each year (directly affecting prime rates). Each shift in the rate has been by either 0.25% or 0.50%, and year over year the prime lending rate has fluctuated by 1.23%

In terms of the discount/premium on the prime rate applied to variable rates, mortgage lenders set this based on their desired market share, competition, marketing strategy, and general credit market conditions. These are the same factors that drive the spread between lenders’ fixed mortgage rates and bond yields.